Summary: As interest rate hikes expectations advance globally, we see government bond yields soaring and yield curves bear-flattening. Risky assets do not show signs of distress yet, as real yields remain in deeply negative territory. The widening of corporate bond spreads is mainly attributable to rising interest rates, primarily affecting high-duration corporate bonds. However, as real yields rise towards 0%, we can also expect credit quality to become a problem. In the emerging market space, hard currency bonds are hard hit by rising yields in the US, while local currency debt remains supported as EM central banks tightened the economy already last year.
Amid market expectations of an aggressive Federal Reserve this year, ten-year US Treasury yields are heading towards 2%. Yet, the more aggressive the central bank is, the slower the future growth, compressing the rise of long-term yields. We expect an acceleration in long-term yields when the Fed provides further details concerning balance sheet policies.
Balance sheet policies will need to come into play. To tighten the economy more efficiently, the Fed might consider combining rate hikes with its balance sheet runoff. That way, the Fed will avoid the yield curve to flatten further, and lift long-term rates. Because the long part of the yield curve is responsible for borrowing and mortgages costs, the central bank will be more effective at tightening the economy. At the same time, it might not need to hike rates as aggressively as the market is currently forecasting.
Hard currency emerging market debt is going to suffer this year as the Federal Reserve hikes interest rates. However, local currency debt will remain supported as the majority of EMs have already hiked rates last year. Therefore, EM’s central banks will not need to tighten their economies, supporting their country’s recovery. That’s why since the beginning of the year, local currency debt remained stable, while hard currency EM debt fell 4% in value.