“One way or the other the world must rebalance, and it will. Major imbalances are unsustainable and always eventually reverse, but there are worse ways and better ways they can do so.”
Prof. Michael Pettis
Commentary & Analysis
A Treasury bond buying opportunity triggered by an emerging market storm?
As you likely know, there has been a lot of damage to emerging market stocks, bonds, and currencies on a relative basis compared to the developed world markets. And you may remember that not too long ago emerging/developing market (EMs)finance ministers were beating the drums of “currency war.” The blame placed squarely on the augustshoulders of Mr. Ben Bernanke and company. The IMF was so concerned; they were openly endorsing the use of capital controls to help EMs to handle the pressure. Well, maybe it’s just a cease fire, but EM finance ministers are now intervening to keep their currencies from “depreciating.” How quickly things can change?
Given the nature of emerging (or developing) world markets, and lack of any depth in their capital markets, i.e. bond markets, relative to the size of money flows from the center from individuals and institutions escaping the zero interest rate regimes and looking for more, the ebb and flow of money can be seen by the track of EM stock market and currency markets. Keep in mind that one has to buy the currency to invest in local stocks of an EM, and one has to sell the stocks and sell the currency locally when one decides to leave. If there was a viable bond market locally, with assorted money market and derivative products available, we likely wouldn’t see the currencies so highly correlated with local stocks. A good example of this can be seen in Brazil. Notice the correlation between the Brazilian real/USD cross and Brazil’s stock marketin the daily chart below:
This price action in stocks and currencies has been playing out in many EMs lately. So it poses a couple of questions:
- As this money leaves EMs, where has it gone?
- Is this flow out of EMs a precursor to a nasty global growth accident ahead?
Wrestling with the first question and thinking about the actions in US Treasuries is a bit confusing. Below is a chart comparing the Thomson Reuters BRIC Stock Index (Brazil, Russia, India and China) versus US Treasury Bond Futures…what I want you to notice here is that usually when there is a sell-off in the BRIC index, US Treasuries rally and vice versa. But notice the action since the latest selloff in the BRIC index, which began back in early May 2013–instead or rallying on this price action, US Treasury bond prices fell, i.e. the price series moved in the same direction.
As JR and I think about this chart, it leads to an interesting set of scenarios. Some a bit more far-fetched than others; but here is what I am thinking:
This money flowing out of EM equities is flowing into US and other developed world equity markets. But, the danger here is two-fold: a) Given the deleveraging by European banks out of EM markets; there is a real possibility of a liquidity crunch, and b) a liquidity crunch in EMs would likely go hand and hand with a big sentiment shift regarding global growth, i.e. it might finally force stock investors to consider the impact on corporate earnings if there is a global growth surprise on the horizon.
Many market conflagrations have been ignited quietly in EMs before growing into a global &^#$ (four letter word starting with “s”)storm. Could this be one of them?
Of course we don’t know. But, if a storm developsit means US Treasuries, as usual, will be the repository of this EM money flow in the end.