Global Macro Themes - The Impact Of Real Yield Trends

  • US real yields have fallen slightly but have remained relatively steady in the past three months. We expect real and nominal yields to rise gradually over the course of 2014 as the recovery gains steam.

  • Eurozone periphery yields have fallen in nominal terms, but the drop in inflation means that real yields are still relatively high, leaving financial conditions on the tight side. We continue to see euro weakness ahead and, eventually, downside for peripheral debt.

  • The Mexican peso stands out as a Latin American currency that could benefit from higher real rates, and we believe that significant upside lies ahead for the MXN versus the EUR.

  • In general, EM real yields are significantly higher than in their developed world counterparts. This is particularly the case across Asia, where we see value in some currencies and local debt markets.

As the global recovery proceeds over the next year, we expect to see real interest rates rise in most economies. In emerging markets, to determine the trend in real rates, we have looked primarily at short-end rates and/or policy rates deflated by headline inflation. With most developed states' central banks running short-term rates at or near the zero nominal bound, however, longer-dated interest rates are a better indication of the direction of monetary conditions.

Although both US and eurozone periphery yields have fallen from their peaks, the dynamics of these declines are very different, and real yields are still higher than they were a couple of years ago. US long-end Treasury yields have stalled and declined somewhat in the past two months, but with inflation coming down, real US yields have remained in positive territory. The US 10-year TIPS breakevens yield chart below shows that the break above 0.00% (representing positive real yields, with 10-year UST yields above expected inflation) made in May 2013 has been sustained. Breakeven inflation in the US has also stalled, with long-term inflation expectations maintained at around 2.4% despite fluctuations in the 10-year Treasury yield. With inflation surprises likely to have bottomed, and with inflation and growth likely to pick up as 2014 proceeds, we remain of the view that UST yields will rise back toward the top of their medium-term range of 2.4%-3.0%. Real yields should also pick up a bit more, representing a tightening in US monetary conditions, as the recovery takes firmer footing. In this respect, the two-year span between mid 2011 and mid 2013 is likely to be remembered as a period of unusually easy monetary policy, with real long-end yields having been negative throughout that period.

Little Fluctuation In The US
US - 10-Year TIPS Yield (LHS) And Inflation Breakeven Rate (RHS)

Global Macro Themes - The Impact Of Real Yield Trends

  • US real yields have fallen slightly but have remained relatively steady in the past three months. We expect real and nominal yields to rise gradually over the course of 2014 as the recovery gains steam.

  • Eurozone periphery yields have fallen in nominal terms, but the drop in inflation means that real yields are still relatively high, leaving financial conditions on the tight side. We continue to see euro weakness ahead and, eventually, downside for peripheral debt.

  • The Mexican peso stands out as a Latin American currency that could benefit from higher real rates, and we believe that significant upside lies ahead for the MXN versus the EUR.

  • In general, EM real yields are significantly higher than in their developed world counterparts. This is particularly the case across Asia, where we see value in some currencies and local debt markets.

As the global recovery proceeds over the next year, we expect to see real interest rates rise in most economies. In emerging markets, to determine the trend in real rates, we have looked primarily at short-end rates and/or policy rates deflated by headline inflation. With most developed states' central banks running short-term rates at or near the zero nominal bound, however, longer-dated interest rates are a better indication of the direction of monetary conditions.

Although both US and eurozone periphery yields have fallen from their peaks, the dynamics of these declines are very different, and real yields are still higher than they were a couple of years ago. US long-end Treasury yields have stalled and declined somewhat in the past two months, but with inflation coming down, real US yields have remained in positive territory. The US 10-year TIPS breakevens yield chart below shows that the break above 0.00% (representing positive real yields, with 10-year UST yields above expected inflation) made in May 2013 has been sustained. Breakeven inflation in the US has also stalled, with long-term inflation expectations maintained at around 2.4% despite fluctuations in the 10-year Treasury yield. With inflation surprises likely to have bottomed, and with inflation and growth likely to pick up as 2014 proceeds, we remain of the view that UST yields will rise back toward the top of their medium-term range of 2.4%-3.0%. Real yields should also pick up a bit more, representing a tightening in US monetary conditions, as the recovery takes firmer footing. In this respect, the two-year span between mid 2011 and mid 2013 is likely to be remembered as a period of unusually easy monetary policy, with real long-end yields having been negative throughout that period.

Little Fluctuation In The US
US - 10-Year TIPS Yield (LHS) And Inflation Breakeven Rate (RHS)

In the eurozone periphery, where falling long-end bond yields have been met with surprise, conditions are not actually easing considerably, due to a concomitant fall in inflation. Several eurozone countries are in outright year-on-year deflation, and as the chart of inflation surprise indices below shows, actual inflation readings have significantly defied expectations to the downside over the past six months.

Big Downside Surprises To Eurozone Inflation
Citi Inflation Surprise Index

Against this backdrop, nominal long-end bond yields have fallen across the eurozone, with most 10-year yields returning to pre-crisis lows. While much of the fall in bond yields from the crisis highs is the result of ECB policy and moral suasion (punctuated by ECB President Mario Draghi's 'whatever it takes' speech of July 2013), since the beginning of 2014 the drop has accelerated, as inflation readings have surprised to the downside.

Separating The Real From The Nominal
Eurozone - 'Real' (LHS) And Nominal (RHS) 10-Year Bond Yields, % (Greece On RHS Axis Of Both Charts)

So despite the drop in nominal yields, the overall change in real yields has not been massive since inflation has more or less kept pace as well. In fact, real yields are higher now than they were in 2007 prior to the global financial crisis, so the drop in nominal yields does not tell the whole story when it comes to eurozone periphery debt sustainability or monetary conditions. We therefore view the drop in yields as a signal that the eurozone recovery is set to be long and stagnant. We believe that the ECB is more and more likely to take action to relieve deflationary pressures, as evidenced by last week's near-commitment by the ECB to ease policy further in June, and we continue to see euro weakness over the rest of 2014. We also see nominal yields at these low levels to be unsustainable and insufficient to compensate for the risk inherent in the debt-laden periphery, but so long as inflation remains low-to-negative, we will wait on the sidelines before going outright bearish periphery debt.

Easing Short-Term, Tightening Versus Pre-Crisis Period
Eurozone - 'Real' Bond Yields Change Since 2007 And Draghi 'Whatever It Takes' Remark In 2012

Latin America - Bottoming Real Rates Point To MXN Strength: About a year ago we argued that interest rates in Latin America have in all likelihood bottomed and are set to head higher over the coming years. Although monetary easing cycles in the region continued since then in some cases (most notably Chile), they have now run their course. Adjusted for inflation, interest rates will be lower this year, staying negative in the case of Mexico (-0.45%), and bottoming at 0.25% and 0.80% in Colombia and Chile respectively. On the flipside, real rates in Brazil are set to peak at 4.95% in 2014, and head lower thereafter. The divergence between Brazil and the other major economies in Latin America is largely down to structurally higher inflation in the former, which despite an extensive rate hiking cycle since April 2013 (375bps to 11.00%) has seen capital outflows and a sizeable sell-off in the currency in the past year. Despite the Brazilian central bank's efforts, real interest rates have remained near historically low levels, thus doing little to reverse capital outflows and stem further exchange rate depreciation.

Real Rates To Head Higher
Latin America - Real Interest Rates, % eop

Shifting balance of payments dynamics notwithstanding, we believe that the trajectory of real interest rates in Latin America will continue to offer valuable insight into the direction of regional exchange rates. For instance, while we currently do not rule out additional near-term appreciation for the Brazilian real, we believe that a shifting focus away from inflation to stimulating economic growth in Brazil, will pave the way for renewed currency weakness in the coming months. Meanwhile, we believe that the Mexican peso arguably has the greatest catch-up potential among Latin American currencies in the foreseeable future, as real rates come out of negative territory. Gains against the US dollar may be muted by rising treasury yields as the US economy continues to recover and monetary policy normalises. However, a growing divergence with a lagging economy in Europe suggests that major value for the Mexican peso exists against the euro, especially ahead of prospective action by the European Central Bank in June. Accordingly, we have initiated a bullish view on the peso against the euro in our Americas Asset Class Strategy table.

In addition to having implications for the movement of Latin American exchange rates, we see shifting real interest rate dynamics in the region impacting economic growth trajectories. In Brazil's case, the high real interest rate in 2014 underpins our forecast of an interest rate cut by year-end to 10.75% as policymakers struggle to stimulate growth (we forecast real GDP growth slowing to 2.0% in 2014 from 2.3% last year). In Mexico, we maintain a more hawkish outlook on monetary policy than consensus estimates currently suggest. This reflects our constructive outlook on the Mexican economy, forecasting real GDP growth to accelerate to 3.3% this year from 1.1% in 2013, and inflation to head gradually higher. Accordingly, we forecast the central bank to hike its policy rate from 3.50% to 3.75% by year-end, and to 4.25% by end-2015, which will see real interest rates climb to 0.55% and place additional upside pressure on the peso.

Asia - High Real Yields Make Bonds Attractive: Local government bond yields across Asia are very attractive at present, with high real yields in most countries likely to provide strong returns over the remainder of the year. The chart below shows a selection of 10-year government bond yields across Asia, adjusted for consumer price inflation (wholesale price inflation in the case of India). The only country which stands out is Japan, where the central bank's efforts to pin down bond yields and create inflation have rendered bonds a particularly unattractive prospect. In our asset class strategy we hold a bullish position on 15-year Australian bonds, and a bearish position on 10-year Japanese bonds. The 200+ basis point spread between the two markets provides strong fundamental support to this view, while the trajectory of inflation (set to rise further in Japan, and fall further in Australia) will provide an additional tailwind to this view. The threat of a fiscal crisis, meanwhile, is an additional factor that could undermine Japanese bonds.

Spot The Odd One Out
Asia - 10-Year Local Currency Government Bond Yields Minus CPI, Basis Points

The high real yield on offer is also a factor in our bullish Indonesian local currency bond position. Not only will positive real yields, together with the trend of lower inflation, keep bond yields anchored, they will also provide support to the rupiah. The spread of policy rates over CPI tends to be correlated with currency performance over the medium term. Indeed, high real yields incorporate both high GDP growth and low inflation, which combined are the two most important factors driving currency performance over the medium term. In the case of Indonesia, the central bank base rate is currently 7.50%, and while CPI is only moderately below this level at present, at 7.3%, we are forecasting this to decline to 5.5% by end-2014. While this will allow the base rate to fall by 50bps, still-strong growth will prevent the need to ease more aggressively. Taken together, these should prove to be very positive developments for the rupiah, which we see ending 2014 at IDR11,000/USD.

These dynamics are not confined to Indonesia. The high real yield on offer across most of Asia is a major driver of our view that, from a total return perspective, Asian FX will continue to outperform the US dollar. With the US dollar likely to rebound over the course of the year against most of its developed market peers, we see significant strength ahead for Asian FX against a basket of developed market FX, excluding the US dollar.

That said, real yields are not the only factor at play when looking at likely currency performance. For example, we hold a relatively constructive view on the Japanese yen in spite of the hugely negative real yields, while we are bearish towards the New Zealand dollar despite solidly positive real yields. Our reasoning is that current valuations are excessively high in the case of the NZD, and excessively low in the case of the JPY, and the reversion to mean will be the dominant driver of performance over the medium term. We also expect yields across New Zealand's bond curve to fall sharply over the coming months, undermining the carry advantage.

Emerging Europe - Decline In Real Yields Ahead: With the exception of Russia and Turkey, nominal government bond yields across major markets in Emerging Europe have pushed lower in 2014, defying expectations for a gradual rise in yields as the regional economic recovery picks up pace. The main driver behind this has been the strong disinflationary trend experienced across 2013/14, particularly within Central Europe, where the trend has bordered on deflationary at points.

High 'Real Yields' To Prove Transitory
Emerging Europe - 10 Year Bond Yield Minus Annual CPI Change, %

As a result, real yields have risen substantially on several sovereigns. Adjusted for inflation, Hungarian 10-year local debt offers a theoretical real yield of 5.4%, Polish 10 year local debt a real yield of 3.5% and Romanian local debt a real yield 4.2%. Nonetheless, these ostensibly attractive real yields are unlikely to be realised by investors. As economic activity accelerates across the region, we believe that inflation has bottomed in Central Europe. The primary reason real yields remain high is because investors likely share our outlook on inflation prospects within the region. The clear outlier is Russia, where real yields remain comparably low at 1.8%, below even that of the Czech Republic at 1.9%, marking it out as the least attractive asset in local currency terms, although decelerating inflation in H214 could help drive up real yields. Overall, we expect real yields across Central Europe will begin to drop across the second half of 2014, in line with our expectations for both inflation and economic activity to pick up.

Sub-Saharan Africa - Favouring East African Local Debt: Of the seven major Sub-Saharan African (SSA) economies with well-developed financial markets (see chart below), only two - Mauritius and South Africa - have negative real interest rates, of -1.4% and -0.2% respectively (we calculate the real interest rate by deducting the latest inflation prints from current 91-day treasury bill yields). Real interest rates are positive on the whole, a factor which supports domestic demand for local debt.

Largely Positive
Sub-Saharan Africa - Select Markets' Real Interest Rates

From a foreign investor perspective we view Kenyan and Ugandan local debt as the most attractive markets over the coming two-to-three months. Both countries offer high nominal yields (8.8% in Kenya and 11.1% in Uganda for 91-day treasury bills), a stable currency outlook and accessibility for offshore participants. We expect yields to be stable over the next few months, forecasting that inflation will be fairly static and interest rates will stay on hold.

Looking beyond the next two-to-three months we expect inflation and interest rates to rise in both Kenya and Uganda. In Kenya, we forecast that inflation will rise from 6.4% in April to 8.8% in December, and in Uganda from 6.7% in April to 8.6% in December. In both countries this increase in inflation will be driven by rising food prices, following a poor summer harvest. This rising inflation will precipitate interest rate hikes: in both markets we forecast a rate hike of 50 basis points by year-end, which would mean rates of 9.0% in Kenya and 12.0% in Uganda. Bond yields will rise concurrently, resulting in a bearish trend for local debt in the final months of 2014.

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