The rise in U.S. yields and resulting pressure on emerging-market currencies has been well documented. But record lows in these currencies could also lead to further yield gains in a “self-reinforcing cycle,” according to Bank of America Merrill Lynch.
Yields on the 10-year note were below 2% at the start of 2013. But that changed as expectations grew stronger about a slowing of the Federal Reserve’s asset purchases in September. The benchmark 10-year Treasury yielded 2.87% in recent action.
As Treasury yields rose, the hunt-for-yield trade that had characterized markets became less necessary. “When Treasury yields were very low, they were relatively unattractive. There was a move to use the cash created by quantitative easing to buy risky assets like emerging-market bonds and currencies,” said Marcus Huie, a rates strategist at Bank of America Merrill Lynch, in an interview. The rise in yields led to a reversal as selling of emerging-market currencies became widespread.
But there’s another factor at play in supporting U.S. yields.
Recent declines in emerging-market currencies, like the rupee and Brazilian real, have sparked fears that those foreign central banks could sell their holdings of U.S. Treasurys in efforts to bolster their own currencies.
“This two-way causation raises the risk of a self-reinforcing cycle between the bond and currency markets, where the Treasury reserve assets are themselves vulnerable to losing value,” Huie wrote in a note Wednesday.
The chart above shows holdings of U.S. Treasurys by foreign central banks. There hasn\’t been a big decline in holdings yet, but concerns of such a selloff are alive in the market, said Huie.
\”The prospect of the ebbing of easy liquidity has exposed many emerging market economies’ vulnerabilities this summer, with India and Indonesia in the eye of the storm in Asia. Despite ongoing sharp correction in the asset markets of both countries, we see no end to the headwinds in the near term,\” wrote Taimur Baig, chief economist at Deutsche Bank Global Markets Research, in a research note Wednesday.
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