Warnings over EM bond bubble as markets break records
Record bond market inflows, low volatility and narrow credit spreads have pot bankers and analysts on alert for a sudden bursting of a bubble — the only problem is that no one is sure what the trigger will be
Emerging markets are complacent about growing risks to global liquidity conditions, policymakers and analysts warned at this week’s IMF annual meetings.
However, they said tightening US monetary policy appeared unlikely to be the trigger for an eventual bond market correction.
EM bond issuance is at a record high, as are flows into both EM and US investment-grade bond funds. Volatility is low and credit spreads are nearing record tights, provoking Brazilian finance minister Henrique Meirelles to warn of the “risk of our next bubble”.
“The level of price of any kind of asset is currently high in the global economy,” said Meirelles. “Policymakers should be watching carefully and measuring their steps.”
With the Fed is in a tightening cycle, the risks to bond markets would usually be clear: higher rates could push up yields in developed markets and suck funds away from riskier assets. But bond bankers are exceedingly bullish and even some central bankers appear calm about the dangers.
“The Fed has communicated as clearly as any central bank could and has learnt its lessons from the 2013,” the governor of the South African Reserve Bank, Lesetja Kganyago, told GlobalMarkets. “We are not going to see another taper tantrum.”
Shanta Devarajan, senior director of development economics at the World Bank, agreed markets expected gradual rate rises but said there was a risk of “substantial” rate hikes if US tax cuts led to a bulging budget. “We have seen this movie before with the [Ronald] Reagan tax cuts and then you had the Latin American debt crisis in the 1980s.”
Colombia’s central bank chief admitted the country had benefited from liquidity via foreign investor flows into its local curve. But Juan José Echavarría, the governor, said his feelings were “mixed”. “The bad news is that you are very worried and nervous about these flows all the time, because they are very mobile.”
Yet even if valuations look exceptionally tight, few are expecting US monetary tightening to be the cause of any correction. Max Volkov, head of Latin America debt capital markets at Bank of America Merrill Lynch, told GlobalMarkets the technical picture remained “very strong”.
“As the Fed continues to hike interest rates, there may be some volatility but there will still be inflows into bond markets,” said Volkov. “The US still has the highest interest rates in the developed world. The one factor that could change things is if we start to see European inflation.”
A bond banker at another firm said retail inflows to EM local and hard currency bond funds were $56bn so far this year — versus net inflows of $12bn for 2012-2016.
If Fed caution is dampening worries about rate rises, economists are looking elsewhere for what exactly could trigger a market correction. “Geopolitical risk is at a pretty high level,” said Roberto Sifón Arévalo, lead analytical manager for the sovereign and international public finance group at S&P.
“Those things are definitely scary and the trigger could be an actual event. We are very cautious in this environment because you talk about events and triggers, they have much more potential to be extremely disruptive.”