Could rising yields on government debt in the developing world be a warning signal?
Thursday 25 Feb 2021 Author: Russ Mould

Zambia, Venezuela, Tajikistan and Armenia do not make a habit of featuring in this column, not least as they are a bit off the beaten track, even for the most intrepid investor. But they catch the eye because each member of this quartet has seen an increase in interest rates this year, to take the total for 2021 so far to five increases and two cuts from global central banks (Mozambique is the fifth for those who are interested).

Those who are not interested will ponder the relevance of this possible trend, but they may need to pay attention for three reasons.

It could be an early ‘risk-off’ sign in financial markets. When investors become incrementally more cautious, they tend to cut their riskiest positions first. Frontier markets such as these, or even more generally, would fit that bill. Their central banks may be raising rates to try and lure capital back or at least reaffirm their credibility
with overseas lenders.

It could be a sign that markets are, at the periphery, starting to deleverage or at least balk at the tidal wave of debt that continues to build – Bloomberg data shows that the total of global bonds in issue now stands at a record-high $67.6 trillion.

And generally speaking, when markets turn cautious, it is the peripheral markets that show distress first, rather than the core ones, as it is in the latter that the bulls always have the greatest faith and thus where they make their final stand before they capitulate and make way for the bears.

It could be a sign that inflationary worries are seeping into government bond markets the world over (see this column). Bloomberg research reveals that the value of global bonds with negative yields has dropped by $3 trillion this year so far, although that still leaves a total of some $14 trillion.

None of these things may come to pass. It could be that the deflationary force of interest payments, demographic trends and central bank intervention keep fixed-income investors in clover as they combine to keep interest rates and inflation well and truly anchored, to the benefit of the bond portion of any portfolio, especially the long-duration segment.

Yet if any of the above three trends keep running, then the meagre coupons offered by most fixed-instruments would leave them looking like return-free risk and speak in favour of short-duration exposure for anyone seeking bond-like ballast in their asset allocation plan.

TURNING TIDE

A quick look at the benchmark 10-year bonds of key emerging markets might suggest that investors are taking risk off the table. Selling bonds here means yields are creeping up and prices creeping down. They might not look like big moves, but the very right-hand side of those lines show an upward shift in bond yields – to 6.59% from 6.15% in the last month alone in Russia.

A look at developed market bonds suggests concerns over gathering debt. In Europe, for example, benchmark 10-year bond yields are creeping higher, despite the European Central Bank’s quantitative easing (QE) scheme.

No wonder when you consider that the world’s debt pile soared by $24 trillion to a record $281 trillion in 2020, according to the Institute of International Finance. That was an extra 35 percentage points of GDP to take the debt/GDP ratio to 355%. Remember that the Global Financial Crisis started in 2008 when the global debt was ‘just’ $187 trillion.

Even the yield on 10-year Japanese Government Bonds (JGBs) stands at 0.10%, the top of the Bank of Japan’s target range and no different from late January 2016. Perhaps even loyal holders of JGBs are contemplating the return of inflation after 30 years.

CHINA SYNDROME

Again, all of these trends could yet fizzle out. In a worst-case scenario, they become more pronounced. Central banks may want to raise rates to curb inflation, if it really does run hot, but struggle to do so, because of the immediate impact this would have economic growth - and financial asset prices. In this context, China is an interesting test case.

The People’s Bank of China jacked up overnight borrowing costs in late January but quickly backed off as the Shanghai Composite index wobbled. As soon as policy was eased, share prices rose. The monetary authorities have a delicate balancing act ahead of them.

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