Geopolitical risks and heavy corporate bond issuance likely to keep a lid on U.S. Treasury prices

While August nonfarm payrolls provided further evidence of a strong U.S. labor market, any ensuing optimism about the domestic economy may spur more pain for emerging markets.

Recent gains in the U.S. dollar against currencies such as the Turkish lira, Russian ruble, South African rand and Argentinian peso, have helped make debt financing for most issuers in these countries more challenging, and have generally led fixed income investors to lower their risk tolerance.

Intensifying global trade tensions between the U.S. and its trading partners, as well as geopolitical uncertainties, including Turkey’s ability to contain inflation and stave potential defaults in its financial system, have also been influencing investors’ flight to safe haven assets.

[IBKR Trader Workstation chart tool shows the downward trajectory of the Vanguard FTSE Emerging Markets ETF (VWO), as well as two emerging market ADRs.]

Against this backdrop, the yield on the 10-year U.S. Treasury note rose roughly 8bps intraday Friday to around 2.95% on the back of a better-than-expected employment report from the Bureau of Labor Statistics.

Total August nonfarm payrolls increased by 201k compared to about 190k anticipated, with job gains in professional and business services (53k), health care (33k), wholesale trade (22k), transportation and warehousing (20k), and mining (6k).

Meanwhile, the unemployment rate was unchanged at 3.9%, and average hourly earnings (AHE) for all workers climbed 0.4% for a year-on-year rise of 2.9%.

Likely Fed response

With the market already widely expecting an additional 25bp rate hike by the Federal Reserve’s Open Market Committee (FOMC) at the conclusion to its two-day policy meeting September 26, the latest jobs figures would appear to have cemented the decision.

Jefferies economists Ward McCarthy and Thomas Simons noted that based on the trajectory of the economy and the “likelihood that inflation will be at or ‘close to’ the symmetric 2% dual mandate objective in the months ahead, the Fed is likely to raise rates in September and December for four rates hikes in 2018.”

However, Jefferies added that given the “imprecision of estimates of a neutral policy rate, the FOMC may decide to slow the pace of rate hikes as the fed funds rate approaches the current SEP long-run rate of 2.90% In that regard, the September SEP could provide some useful insight.”

Corporate bond effects

Overall, improvements in the U.S. economy will likely continue luring investors to the yield offered in the primary corporate bond market – especially those investors who have been priced out of their local markets, or have a dearth of available paper, or who have decided that emerging market debt has become too risky.

For the week ended August 29, Thomson Reuters/Lipper U.S. Fund Flows reported a net inflow of roughly US$2.25bn into investment-grade corporate bond funds, while emerging market debt funds experienced a net inflow of a paltry US$250m.

Amid the recent risk aversion, certain emerging market corporate bonds have been suffering.

To date, Russian diamond miner Alrosa (ALRS), for instance, has seen the yield on its 7.75% notes due November 2020 climb close to 1.6% to roughly 4.8% since November 2017, and Chinese aluminum giant Chinalco’s (CHALUM) 3.625% bonds maturing December 2019 have risen around 1.25% to nearly 4.0% since September 2017.

For ETF and ADR investors, the Vanguard FTSE Emerging Markets ETF (VWO) has lost a little more than 20% from its 52-week high set in late January, while Russian steel pipe supplier TMK (TMKXY) and the Aluminum Corporation of China (ACH) shed around 21% and 57% from their respective 52-week highs set in the latter part of 2017.

In contrast, demand for high grade corporate bonds, and still-low U.S. interest rates, has helped trigger a tsunami of recent primary market sales.

Ron Quigley, head of fixed income syndicate at Mischler Financial, noted that Thursday’s US$20bn, 10-part bond from Cigna (CI) propelled this past week into first place as the highest volume week to date in 2018 for investment-grade corporate only issuance – totaling US$56.10bn.

Demand on Thursday was also decent, with the average spread compression across the pricing evolution of the 14 corporate deals that crossed the tapes was around 15.75bps compared to 14.15bps for the week.

In the meantime, on a month-to-date basis, Quigley calculated that priced deals to date in September have reached just north of 46% of most syndicate managers’ midpoint average, as well as eyed the potential for an additional US$30bn to price in the week ahead.

For now, the hefty volume of U.S. dollar-denominated corporate issuance is also likely to keep a lid on lower U.S. Treasury prices.