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Categorized | Capital Markets

Dollar rally heaps pressure on emerging-market bonds

Posted on November 18, 2016

Emerging market bonds denominated in dollars are nursing some of the biggest losses from the post-US election bond sell-off, as the rally in the greenback puts extra pressure on countries’ ability to service their debts.

The so-called “Trumpflation” trade has seen bond yields and the dollar climb as investors expect fiscal stimulus in the US to boost inflation rates, which reduce the real value of a bond’s returns. (Rising yields reflect falling prices.) Emerging markets have been particularly badly hit thanks to fears that protectionist trade policies in the US could harm global trade.

The Bank for International Settlements warned almost two years ago that a prolonged rally in the dollar could expose financial vulnerabilities in emerging markets after years of increasing amounts of dollar-denominated debt issuances. Since that warning, the dollar index has climbed almost 12 per cent.

Despite dipping slightly this week, yields on Mexico’s 10-year dollar-denominated debt are still up 97.2 basis points (0.972 percentage points) since the election. Yields on its local-currency debt, in contrast, have risen 92.8 basis points, but from a much higher base. In percentage terms, the dollar-denominated yield has increased 30 per cent, compared to only 15 per cent for the peso debt.

That’s a rough enough sell-off as it is, but is exacerbated by the 11 per cent drop in the value of the Mexican peso in the same period, which makes it more expensive to repay and service debt in foreign currencies.

Turkey is in a similarly difficult situation, with yields on its 10-year dollar debt up 81.3 basis points since the election. Although they have fallen back from the two-and-a-half year highs hit at the end of last week, they’ve climbed back another 13 basis points today. In percentage terms, the yield has increased by 16 per cent, compared to only 6.5 per cent for its lira-denominated debt.

Even Russia, which is less directly exposed to the US economy and is looking to benefit from better relations under the new president, has suffered, with yields on its foreign-currency bonds now higher than when it made its return to international debt markets in July.

At its worst, continued dollar strength can create a vicious cycle whereby the expectation that debt will be harder to service drives up bond yields, exacerbating fears that the country could struggle to service debt, causing the local currency to weaken even further as investors move to safer assets.

Charts: Bloomberg