The long term interest rate front has seen some real action this month. The attack on the prevailing very low yields was led by the German Bunds. It would appear that the modestly positive GDP growth recorded in Europe in the first quarter of 2015 – hence an expected increase in demands for capital to invest – was the trigger for this move.
Europe’s GDP expanded by 0.4% from the previous quarter, or 1.6% at an annualised rate. Further encouragement was to be found in the extension of better growth rates from Germany (where the quarterly growth rate receded slightly) to Italy and France.
US Treasury Bond and RSA bond yields predictably followed the Bunds higher. We illustrate this in the chart below, where the log scale better tells the story of rising yields in proportionate terms. The 10 year Bund yield increased from very close to zero (0.14%) at the April month end to a level of 0.72% on 13 May. Over the same two week period, the yield on the 10 year US Treasury Bond rose from 2.06% at April month end to 2.27% by the close on the 13 May. The 10 year RSA yield increased from 7.85% to 7.994%, slightly lower than the 8.051% registered at the close of trade the day before.
Accordingly, the spread between US and German yields, which had widened significantly earlier in the year, has narrowed sharply, to the advantage of the euro. The greater confidence in European recovery prospects helped send euro yields higher. The somewhat mixed picture about the robustness of the US economy, accompanied as it has been by weaker than expected spending at retail level, thus implying reluctance by the Fed to raise its short rates soon, helped restrain the increase in US yields. This narrowed the spread or interest rate carry and reduced the demand for US dollars.
The evidence suggests that the wider the spread in favour of US bonds, the stronger will be the dollar. The opposite has tended to be true of the rand and other emerging market currencies. The wider the spread in favour of the RSAs, the weaker has been the rand. This interest rate spread can be regarded as the risk premium carried by SA borrowers to compensate for the expected depreciation of the rand, as well as (presumably) sovereign risks. The RSA-USA 10 year yield spread, now 5.72%, is marginally lower than it was on 30 April 2015. It has moved within a rather narrow range since 2013, recording an average daily spread of 5.34%, with a maximum of 6.17% and a minimum of 4.31%.
It can be confidently expected that RSA rates will continue to follow equivalent US rates higher or lower; and that US rates will take their lead from euro rates. However, such co-movement of long term interest rates can be modified by changes in these interest rate spreads. The spread between RSA and US rates, that is SA risk, will be influenced by simultaneous changes in the outlook for the SA economy. The better/worse are SA growth rates (for example), the more capital will flow towards or away from SA, so narrowing or widening the spread and strengthening or weakening the rand.
But the spread will depend more consistently on a day to day basis on the outlook for emerging markets generally. Capital flows into and out of these economies and capital markets will respond to the expectations of emerging market growth and its implications for earnings of companies listed on their stock markets. The JSE All Share Index, when measured in US dollars, follows the emerging market benchmark indices very closely. This is because when capital flows into or out of these markets generally, the JSE consistently attracts or gives up a small, but predictable, share of such capital flows in the same direction. For any given level of global interest rates, the more confidence there is in emerging market growth, the narrower the risk or interest rate spread against the rand is likely to be, hence the stronger the rand is likely to be and the higher will be the US dollar value of emerging markets and JSE equities and bonds.
In the chart below we show how the MSCI Emerging Market Index and the JSE All Share Index (in US dollars) behave very similarly. It also shows how the two indices have underperformed the S&P 500 over recent years as the spread between SA and US interest rates have widened. We show these same trends in 2015.
These developments raise the issue of whether rising interest rates themselves (adjusted for changes in risk spreads) represent a threat to or an opportunity for investors in emerging equity and bond markets. Past performance suggests that rising rates in the US are much more likely to be associated with relative and absolute strength in emerging markets rather than weakness. The explanation for this seems clear enough. Rising rates in the US and Europe will accompany stronger growth and an improved growth outlook. Such growth in the developed world is helpful to the growth prospects in emerging economies, for which the developed economies are important sources of demand for their exports. A rising tide in the developed world will lift all boats – including those moored in the emerging economies.
The following figure strongly suggests as much. It shows how rapidly rising interest rates in the US between 2003 and 2007 were been associated with declining risk spreads for the emerging bond markets. The lower interest rates after the financial crisis in 2008 were in turn associated with greater emerging market bond risks. These risk spreads are represented by the average of the five year credit default swap spreads over US Treasury yields for Turkey, SA, Mexico and Brazil.
Presumably these risks of default decline as growth prospects improve. And improved growth prospects (lower risk) are well associated with higher share prices. In the figure below we show the relationship between the value of the MSCI Emerging Market Index benchmark and the JSE ALSI and the CDS risk spread over recent years. We show how the CDS spread for RSA five year US dollar-denominated debt and the JSE in US dollars have moved in consistently opposite directions.
These relationships would suggest that the threat to the JSE and the rand will not be higher rates in the US and Europe, provided they are accompanied by improved global growth prospects. The threat however to the rand, the RSA bond market and the SA economy plays might still come from SA specific factors. These include strikes, load shedding and higher short rates imposed by the Reserve Bank that prevent the SA economy from participating in a faster growing global economy. The objective of the SA economic policy makers is to avoid such pitfalls.