Asia Rates: Geopolitics and Fed

This report is a follow-up update on Asia Rates: Assessing the impact from Russia-Ukraine published on 28 Feb.

Since the onset of Russia's invasion of Ukraine, two factors have driven global government bonds (DM, EM local currency). The first pertained to the size of economic impact from the conflict itself. The second was the positive and negative exposure to oil and other commodity prices (importer or exporter). While Asian economies have negligible economic exposure to Russia-Ukraine, countries with oil trade deficits are vulnerable to higher oil prices.

Geopolitical tensions and risks surrounding Russia's invasion of Ukraine have intensified over the past week. Western nations have imposed more aggressive and punitive sanctions, including banning a few Russian banks from the SWIFT system and restricting access to the Central Bank of Russia's FX assets and reserves. Russia has also banned foreigners from selling equity and fixed-income securities to limit outflows and support its currency.

At this juncture, the military and financial situation are highly fluid, and things could take a sharp turn for the worse. We cannot discount the possibility of extreme and damaging scenarios such as Russia defaulting on its financial obligations or Russia cutting off its oil and gas exports. From Asia's fixed income perspective, we cannot ignore the possibility of financial contagion and broad-based and deep selloff across EM local assets.

We had recently turned neutral on Asia rates and bonds, but considering the latest developments, we will have to return to a more cautious/defensive stance. The combination of a Fed that will still be hiking to fight inflation and uncertainty and risk aversion around geopolitics and global energy supply cannot possibly be a conducive macro environment for Asia rate and bonds to perform. The accompanying market moves, flattening the US yield curve and rising VIX, form a market setup that historically, Asia rates and bonds don't do well.

In the current environment, we view the outlook for Asia rates and bonds through the lens of three drivers, which encompasses US rates and USD tightening risks from the upcoming Fed hike cycle and geopolitical risks around Russia.

1^st Driver: Fed hike cycle/US rates

The latest comments by Fed Chair Powell and other Fed officials suggest that, despite geopolitics, the Fed is still prepared to proceed with rate hikes to fight elevated US inflation. Their focus on bringing inflation lower could mean staying on a hiking path in the coming months and reducing their balance sheet. With policy settings still far from neutral, it would probably take a sizable economic or financial sector shock to derail the Fed. Accordingly, the Fed will probably still be a major source of volatility for Asia rates and bonds in 2022.

US curve-flattening dynamics will not support Asia rates and bonds. Short-term (2Y) US rates are elevated on Fed tightening expectations while long-term (10Y) rates are lower on stagflation worries and risk aversion.

For our analysis on how Asia rates have performed in past Fed hike cycles, please refer to our Asia Rates 2022 Outlook.

2^nd Driver: Oil prices

As written in our last report, we expect the oil driver to be dominant in driving relative bond returns in the near term. We continue to favour staying overweight on Malaysia MGS, China CGB and Singapore SGS bonds. Malaysia has the only oil and gas trade surplus in the region. Our economists expect more monetary easing in China. The recent back-up in CGB yields on January's strong credit data presents an opportunity to establish long positions. SGS is a viable alternative that looks cheap (relative to UST) as a safety play (see USD & SGD Rates: How to think about insurance policy?).

For the other Asia local currency government bonds, we favour a marketweight or slight underweight stance, largely due to their negative exposures to higher oil prices. In the particular case of IndoGBs, we recognize that the boost to terms-of-trade and trade balances from higher coal and CPO prices is likely more than to offset the drag from higher crude oil prices. However, we refrain from turning bullish IndoGBs for now because of IndoGB's high weights in EM bond benchmarks (more susceptible to broad outflows from EM bond funds).

In our last report, we had used oil trade balances and overall current account balances to compare across Asian economies and judge which rates markets could be more vulnerable or resilient. This report extends our comparison to include real policy rates and beta sensitivities to Brent prices. The inclusion of two new metrics doesn't change our assessment. Fundamentally, Thai and Indian rates and bonds should cheapen the most against rising oil prices, followed by Korea. In terms of resilience to higher oil prices, Malaysia and Indonesia rates and bonds rank the best within the region.

* Asia Rates: Impact from rising energy prices
** 2021 Current Account consensus forecast (Bloomberg)
^ Current policy rate – 2022 CPI consensus forecast (Bloomberg)
^^ Bps change for every $1 increase in Brent price

3^rd Driver: Risk aversion and funding

With higher oil prices, the impact on Asia's growth, inflation and current accounts are relatively well-understood and widely modelled (i.e., a known-known risk). On the other hand, risk aversion is the key known-unknown risk.

Risk aversion typically manifests via equity and bond outflows and pricing greater risk premium across Asia rates. Over the past week, we see moderate bond outflows in IndoGBs and large outflows from ThaiGBs. Our bias assumes that other Asia bond markets are also seeing outflows. However, due to the lack of daily data, we would be able to verify only when the monthly data becomes available.

Risk aversion could also manifest via funding markets. Over the last few days, there have been notable moves in USD FRA/OIS spreads and EUR, JPY cross-currency bases and implied yields, suggesting that global USD funding premium would be something to watch in the coming weeks. There have been fewer signs of funding stress or tight liquidity in Asia local funding markets. That said, funding conditions could deteriorate swiftly and we would expect to see some volatility in short-term funding rates in the near term.

Risk aversion and volatility in funding markets typically combine to drive deleveraging and de-risking in financial markets. Trades that are overcrowded or have heavy positioning could be particularly vulnerable to unwinds. Coming into Russia-Ukraine, we identify the following three Asia rates strategies where prior positioning was likely relatively heavy.

1) Long CNY IRS/NDIRS and CGB to position for PBOC easing

2) Receive short-term SGD OIS/IRS vs pay USD OIS/IRS to position for expected outperformance of SGD rates from MAS policy tightening

3) Long BOT bonds or short-tenor ThaiGB bonds as a play on Thailand's tourism recovery prospects

We think there are fewer deleveraging/de-risking risks around Strategy (1) because there seems to be some safe-haven demand for CGBs and PBOC's easing bias would be a sufficiently strong anchor for CNY rates. On the other hand, we think there could be some deleveraging/de-risking risks around Strategies (2) and (3). For Strategy (2), if USD rates fall, SGD rates' recent outperformance against USD rates will likely reverse, further triggering unwinds. For Strategy (3), worsening geopolitics could weigh on tourism recovery prospects and higher Thai inflation prints (Feb CPI printed 5.28% YoY) increase the risks of that Bank of Thailand could turn hawkish sooner.

Adjustment to our Asia rates ideas

Given the larger negative exposure of Thai rates and bonds to rising oil prices and likely heavy receive/long positioning on short-tenor Thai bonds, we are closing out our receive THB 1Y1Y NDIRS idea at a loss to pre-empt further losses.