Emerging Markets: Steepening Treasuries curb appeal – BNY

BNY's Geoff Yu notes that sovereign bonds from commodity-based emerging market (EM) economies experienced heightened selling following the Fed's decision, even as the dollar weakened and U.S. real yields declined. South Africa, despite higher gold prices, failed to attract inflows, as EM duration faces challenges due to inadequate nominal yields, inflation risks, and fiscal stress compared to the stable U.S. yield environment.

Typically, EM sovereign debt benefits from dollar-funded trades in a dovish Fed scenario, but post-Fed selling has intensified. There are indications of a potential reversal, yet South Africa, which should gain from higher gold prices, hasn't seen any inflows since the decision, signaling ongoing difficulties for EM duration. Nominal yields for both front and back ends remain insufficient to offset inflation risks and fiscal strain.

Given the current global growth outlook and the fiscal impacts of the Iran conflict, this sentiment is understandable. Central banks cannot enforce fiscal discipline as effectively as bond markets do, and the required price adjustment has not yet materialized for sustainable EM asset recovery. Developed market sovereign bonds continue to enjoy robust domestic support amid the Iran conflict, but the Fed decision significantly altered U.S. breakevens, with the 5y5y forward measure increasing by 20bp over the past month and surpassing March lows by nearly 30bp.

Despite the decline in U.S. real yields, this boost hasn't been sufficient to drive significant inflows into commodity-linked bonds, as the steepening Treasury curve has largely negated this advantage. The weaker dollar outlook persists, yet it doesn't inherently lead to higher commodity prices or stronger commodity-linked economies, especially when U.S. investors remain content with domestic nominal and real yields.

EM economies must generate their own growth and total-return narrative to fully capitalize on easier global financial conditions. The earlier combination of a significant yield edge over the U.S. and robust Chinese demand bolstering export revenues is no longer present.