Renewed volatility in bond and currency markets. Learning the lessons of monetary history.
Europe (especially Italy, but also Spain) rather than emerging markets (especially Turkey) has become the new focus of attention in financial markets. Bond yields in Italy and Spain have increased sharply in recent days. The two year Italian bond yield is up from zero a few days ago to the current 2.82% while the spread between 10 year Italian bonds and German Bund yields have risen from 1% to 2.87% in three days.
Rising US interest rates were the proximate cause of some earlier distress in emerging bond markets and now in the past few days have reversed course. From a recent high of 3.12% the yield on the key 10-year US Treasury Bond has fallen back to 2.83%. RSA bond yields have also receded in line with Treasury bond yields. Yesterday they were at 8.59% and about 28 basis points lower than their recent high of 8.87% on 21 May. However the risk spread with US Treasuries has widened marginally, from recent lows.
While long term interest rates in the US have fallen back, the US dollar has strengthened further against the euro and most currencies, including emerging market (EM) currencies like the rand. German Bunds are another safe haven and the 10-year Bund yield has also declined, from 0.64% earlier this month to the current 0.33%. This has allowed the spread between Treasuries and Bunds to widen further – to 2.6%, helping to add strength to the US dollar.
It should be appreciated that RSA bonds have held up well under increased pressure from US rates and now also some European interest rates. In figure 4 we compare RSA dollar denominated five year (Yankee) bond yields with those of five year dollar bonds issued Turkey and Brazil. While all the yields on these dollar denominated bonds have risen and also very recently have fallen back, the RSAs have performed relatively well.
The US dollar went through an extended period of weakness against its developed market peers and EM currencies between mid-2016 and the first quarter of 2018, after which the dollar gained renewed strength. Dollar strength can be a particular strength to EM currencies and the recent episode of dollar strength has proved no exception in this regard.
As we show below in figures 5 and 6, the rand performed significantly better than the EM Currency Index from December 2017 and has recently performed in line with the average EM currency vs the US dollar and much better than the Argentine peso and the Turkish lira recently. In figure 6 the declining ratio EM/ZAR indicates relative rand strength.
We may hope that the rand will not be subject to any crisis of confidence. So far so good. But were the rand to come under similarly severe pressure as has the Turkish lira, one would hope that the Reserve Bank would avoid the vain and expensive attempts to defend exchange rates that Argentina and Turkey have made. Throwing limited forex reserves and much higher short term interest rates at the problem can only do further harm to the real economy – and very little to stem an outflow of capital. As has been the latest case with Turkey and Argentina.
It was the mistake the Governor of the Reserve Bank Chris Stals made in 1998 when failing to defend the rand during that emerging market crisis. The best way to deal with a run on a currency – caused by exposure to a suddenly stronger dollar – is to ignore it. That is to let the exchange rate absorb the shock and live with the (temporary) consequences for inflation. Defending the currency provides speculators with a one way bet against the central bank attempting to defend the indefensible. It is much better to let them bet against each other and let the market find its own equilibrium. The renewed volatility in Europe, we may also hope, will continue to hold down US and RSA interest rates – and deflect attention from emerging markets. 30 May 2018