The rise in yields of US Treasuries, which began in August, saw the 10-year yield reach 5.0% this week. The bond market is pricing higher-for-longer yields. What’s new is a narrowing of the 2-year/10-year yield gap, a bearish flattening of the yield curve. We expect the impact of this move on Asian financial assets to be modest due to the region’s strong fundamentals. While we are constructive on local currency emerging Asian bonds, idiosyncratic factors could lead to regional pricing divergences.
There is a host of short-term factors putting upward pressure on US bond yields including:
- US growth still surprising to the upside
- A hawkish Federal Reserve (inflation is still too high for its comfort)
- Loose fiscal policy (with a US presidential election in 2024)
- Large quarterly refundings and quantitative tightening
- A weak Japanese yen making US Treasuries less attractive for Japanese investors
In addition, there are structural and long-run factors:
- The potential for higher GDP trend growth (through, perhaps, artificial intelligence)
- Worries about US debt sustainability
- Structurally higher inflation risks arising from factors such as deglobalisation and the energy transition
Consequently, the yield gap between the short- and long-end of the yield curve has narrowed as longer-dated US bond yields rise faster than shorter-dated ones (see Exhibit 1).
Typically, towards the end of a monetary policy tightening cycle, we would expect short-dated yields to fall faster than longer dated yields as market expectations of rate cuts kick in – a so-called bullish steepening, or disinversion, of the yield curve.
What we see currently, however, is a bearish steepening with the 10-year yield rising faster than the 2-year yield. This suggests markets are pricing additional risk, the so-called term premium, for holding long-dated bonds.
Asymmetrical market reaction
The steepening appears to be consistent with the market’s asymmetrical reaction to economic and inflation news. Recently, upside surprises to growth have brought sharp increases in long bond yields, while downside surprises to inflation have met with muted bond rallies.
Such a reaction suggests that better-than-expected growth is fuelling investor doubts about the sustainability of the inflation slowdown – in other words, upside growth surprises are boosting long yields more than downside inflation surprises are reducing them.
Recent US economic data has indeed signaled resilience. The economy continues to create jobs at a high rate, and consumers show little sign of ending their spending spree. Data on industrial production, factory orders, and building permits have all surprised to the upside.
The rise in US Treasury yields has led to tighter financial conditions and should eventually slow the pace of both growth and inflation. Fed Chair Jerome Powell remarked on this recently, saying that ‘financial conditions have tightened significantly, and longer-term bond yields have been an important driving factor in this tightening’.
In the view of our multi-asset team, tighter financial conditions will weigh on the US economy and lead to lower bond yields. For this reason, we are overweight nominal US Treasuries and inflation-linked bonds.
Impact on Asian emerging markets
As a US-dollar-bloc region, tightening US liquidity and rising US Treasury yields should have a negative impact on emerging Asia. However, Asia’s better economic fundamentals may provide a cushion. Its average inflation rate is only about half of that in developed markets (see Exhibit 2).
Furthermore, consumer price index (CPI) inflation rates in Asia are already in the target zones for 80% of the region’s central banks, while inflation remains above target in Europe, the UK and the US. Asian central banks were thus able to put their monetary policy hikes on hold ahead of the US. This underlies our constructive stance on EM Asia local currency debt.
Investors naturally differentiate between markets based on economic buffers such as the current account balance, inflation, and the yield differential with the US (see Exhibit 3). Low yielders with weak economic buffers — notably a current account deficit and high inflation — are the most exposed to the risk of declining US liquidity and should hence command a higher risk premium.
India, the Philippines and Thailand are the most exposed to the impact of higher-for-longer US yields due to the size of their current account deficits and high inflation rates. They are also potentially more vulnerable to a fall in markets if risk-off trades kick in. Countries with large current account surpluses and low inflation such as China, Malaysia and Taiwan should be more resilient.