Rates 10y Dashboard: Which Countries Stand to Benefit as EM Rates Volatility Falls?

The nonfarm payroll employment data in the US for June came in broadly in line with expectations last week. The US 10y yield has drifted lower since the data release, approaching the 1.4% threshold where it last traded in March. US rates volatility (Move Index) also continues to slide lower. With several key developments and data that the market was watching now behind, the US Treasuries may be headed for a summer lull until the Fed’s Jackson Hold Symposium in late August.

If indeed we are entering a low-volatility period for US rates, then we can expect the same for EM rates, any idiosyncratic developments aside. Indeed, as the chart below shows, similar to US rates volatility, EM rates volatility is off its March peak and is below its long-term average. Moreover, EM rates volatility has retreated to levels last seen earlier this year. If US rates volatility continues to fall, then EM rates volatility could test its multi-year lows.

Data Source: Refinitiv; Note: EM = equally weighted index of rates in 19 countries

A low-volatility period should allow EM rates to make up for their previous underperformance, as shown in the chart below. As we discussed in a previous note, the spread of EM rates to the US is close to its widest since 2016, barring the brief spike during March 2020 at the start of the pandemic. Historically, the EM-US spread tends to tighten when volatility falls.

Data Source: Refinitiv; Note: EM = equally weighted index of rates in 19 countries

The risk premia in the long end of EM curves has gone up on a combination of fiscal slippage leading to worsening debt dynamics, inflationary risk as central banks were behind the curve, and idiosyncratic developments in several countries including Colombia, Peru, Chile, Brazil and Turkey.

Of these three, the inflation risk has tempered as many countries have started raising rates (e.g., Mexico, Czechia, and Hungary last month). Even the country-specific risks appear to be falling especially in the Latin American countries. As such, while some of the risk premium built in EM long-end rates related to fiscal deterioration may take longer to abate, there is room for the EM-US spread to narrow in our view.

One way to identify the countries where the long-end rates can outperform is to look at the yields versus volatility chart (see below) and focus on the outliers. Some of the countries, including Chile, Colombia, Mexico, South Africa, and India, overlap with those we have previously identified as ideal for flatteners (see here).

Of these countries, in India, while we like a flattener, we are not inclined to an outright trade as we expect the curve to bearishly flatten when the central bank eventually raises rates as it is behind the curve in our view (see here). Besides the countries mentioned above, we would include Indonesia and Russia in the list. Recall that in Russia, we have recommended a curve steepener. Long-end rates still make sense as we are expecting bullish steepening of the curve.

Data Source: Refinitiv; Note: EM = equally weighted index of rates in 19 countries

Best Longs / Best Shorts

• To the list of underperformers based on our models in the attached Rates 10y Dashboard pdf, we added back Peru 10y (PEN 10y) as its z-score exceeded 1, both on an outright basis and based on the spread to the US.
• The list already had Chile 10y (CLP 10y) and Colombia 10y (COP 10y) on it.
• Meanwhile, the list of outperformers stayed empty.

Best Crosses

• The list of preferred relative-value trades based on our models changed to Receive CLP 10y vs Pay Thailand 10y (THB 10y) or Israel 10y (ILS 10y) or South Africa 10y (ZAR 10y) or China 10y (CNY 10y).
• The 3m expected returns for these pairs went up to the range of 11.5-13.5% (not annualized), assuming mean reversion.