Bond investors have been hit hard this month as the US recovers and people get ready for the end of qualitative easing; the effects have proven to be farther reaching than many expected as beta between US Treasury bonds (UST) and European government bonds increase. Emerging markets are also taking a big hit as a result, explains Societe Generale analysts Vincent Chaigneau, Mary-Beth Fisher, and Wee-Khoon Chong in a recent report.

Correlation between US bonds and European bonds

USTs were expected to be sold off as the US economy improves, but the strong correlation between USTs and European bonds has taken many people by surprise — 10 year gilt bond yields went up 49 bp versus 43 bp for UST and 41 bp for Bund. “In the US, the impact is augmented by the data dependency of the timing and pace of Fed tapering. An additional concern lies in the lack of an obvious marginal buyer when the Fed pulls back,” the Soc Gen report explains. “The TICS data certainly gave the market no comfort about the appetite of foreign investors for US assets in general and Treasuries in particular.”

Economic data from the UK is much better than expected and the rest of Europe has also surprised, which hasn’t helped fixed-income investors much either. “UK data improvement has aggravated the defiance against the BoE-style forward guidance; no doubt Carney will try to fight the market’s doubts, but our economists outline that guidance based on the UK unemployment rate is on very shaky grounds.”

European bond PMIs up

Correlation between UST yields and emerging market currencies

Fixed-income investors aren’t the only ones suffering. There is a strong correlation between UST yields and emerging market currencies. Investors have been pulling their money out of those markets in anticipation of more lucrative opportunities in economies that have less political and systemic risk. Without a regular stream of hard currency, many developing countries will struggle to get the resources their economies need, which means that a sell-off in emerging market currencies can often be followed by a sell-off of other EM assets. “Fears of capital flight, as UST yields rise, are causing financial stress and raising concerns about EM economic performance,” the report says. “We fear more misery there over the coming weeks.”

EM currency v UST