The Daily Update - US rising rates but lower long term growth and creditworthiness

With a Federal Funds Target Rate hike expected later today, futures markets have already priced in a 25bp rise following recent strong data, hawkish official comments and waning of external risks. Indeed with USD10bn already shorting Blackrock bond ETFs, announcement swings (if any) could go either way. Focus instead will be on the trajectory of future hikes and any words on future balance sheet reductions. Given that 3-4 hikes were expected in 2016 (and considered gradual back then) a rate rise today supports a similar expectation for the Fed for this year. Three rate rises this year still look more likely than four and we expect any balance sheet reductions will come with the next hike; downplaying their significance. But whatever the trajectory the longer run target remains constrained around the 3% mark. This is an important point that is often understated. As Fed buff Tim Duy summarises, ‘A higher estimate of the neutral rate would be much more hawkish than just quickening the pace slightly to that rate.’

Following the global financial crisis, the Fed Funds Target Rate was cut sharply from 2% to 0.25% where it remained for almost 7 years and has since gradually risen to 0.75% (or perhaps 1% if you are reading this post-Fed announcement). But over this time, as current rates were held and have now started to rise, the Fed Funds Longer Run Target Rate (implied from the dot plot) has steadily dropped from 4.25% in 2012 to now just 3%. And although the December average reading showed a slight rise, this was mostly due to a couple of votes moving up from 2.5% to 2.75%. Even with the new voting members, we expect that the long run target will remain around this 3% level; as such any forthcoming rises in Fed Funds pose more of a risk to shorter term Treasuries under a bear flattening scenario. This also creates tougher funding conditions for other shorter-term debt, particularly less creditworthy sovereigns and corporates that are overly reliant on shorter-term funding.

This is another consideration worth highlighting in our investment philosophy, the asymmetric risks across emerging market debts; and why we target value high-grade credits and favour sovereign and quasi-sovereign credits from net creditor countries. Over recent years the hunt for yield has helped spur growth in emerging market debt. According to a recent report from JP Morgan total EM local debt has grown to USD16.3tn; this seems substantial considering it is three times the size of developed market investment grade corporate debt (5.5tn). With such unwieldy figures, it’s easy to worry that this debt pile is uniformly vulnerable in the face of rising rates in America and increasing negative sentiment towards bonds.

But creditworthiness across emerging markets varies wildly; indeed we invest in many countries considered emerging markets that not only are net foreign creditors but have a higher GDP per capita than many developed markets. The dated ‘emerging market’ nomenclature can be misleading. Not only this but comparing total EM local debt to only DM corporates is also misleading as it ignores the gargantuan sovereign debts across developed markets. Taking total debt, developed markets have around 4x emerging market debt, despite only having around one quarter the population. EM debt is currently around USD60tn according the Institute of International Finance; the US public debt alone is fast approaching USD20tn. Given that current short-term debt-fuelled stimulus and optimism in the US is unlikely to translate into stronger longer term growth, and differentiation within emerging markets still provides yield enhancing opportunities amongst those not too heavily indebted: we remain positioned in attractive risk -adjusted value, longer-term investments across higher grade credits.