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Is DM bond issuance ‘crowding out’ EM?

Market Commentary

25 September 2020

As the twin burdens of coronavirus and late business cycle dynamics increasingly weigh on growth prospects in developed markets (DMs), governments have been quick to spend more. Current Bloomberg consensus forecasts suggest that the United States (US) will rack up a fiscal deficit of nearly 17% of GDP in 2020, while Germany is expected to spend 8% of GDP more than it takes in revenues this year. The fiscal deficits in the rest of Western Europe are also expected to average about 8% of GDP, while the UK is on track for a fiscal deficit of 14% of GDP. In Japan, investors expect a deficit of around 11% of GDP in 2020.

None of the governments in the major DMs are contemplating tax increases in the current economic environment, so the unprecedented fiscal deficits will be financed with debt. The supply of bonds will rise sharply. Will this push up rates in DM and somehow ‘crowd out’ Emerging Market (EM) fixed income?

In our view, there is no evidence that increased supply of bonds in DMs has ‘crowded out’ EM bond markets through the conventional ‘interest rate effect’, that is, higher DM bond yields. In fact, the massive incremental supply of bonds in DMs has been associated with lower DM bond yields, which, all else being even, ought to have ‘crowded in’ EM bond markets. Yet, ‘crowding in’ has not happened either, because institutional investors have generally reduced their exposure to EM fixed income markets in recent years rather than ‘reach’ for yield.

These seemingly contradictory observations – greater supply of bonds, lower bond yields, flight from rather than search for yield in EM – can easily be reconciled if one thinks of Quantitative Easing (QE) policies for what they are: interest rate subsidies. They have introduced massive distortions in global financial markets and precipitated a massive ‘volume effect’, whereby capital moved in size from EMs towards DMs.

The rest of this short note explains: (a) why DM bond issuance has not ‘crowded out’ EM debt in the conventional sense; (b) how EM has been impacted by QE policies in DMs; (c) the impact of QE policies on economic performance in DMs; (d) implications for the Dollar; and, (e) return prospects for investors going forward.

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