Asia Rates: Challenging times ahead

Weighed by Omicron and Fed’s pivot
Duncan Tan02 Dec 2021
    Photo credit: Unsplash Photo

    Asia local currency government bond investors have had much to digest in recent days. First, the potential severity of the Omicron variant and its impact on global normalization and recovery. Second, Fed Chair Powell's comments which raised the prospects of an accelerated taper and earlier lift-off on the Fed Funds rate. On its own, perhaps slightly counter-intuitive, recent global developments around the Omicron can be positive for Asia bonds. As a case in point, Asia bonds performance have been strongest in April and August this year, when several Asian countries were especially hard hit by the Delta variant. This really speaks to how the pandemic has impacted Asia macro, particularly on flows. Based on the Delta experience, the Omicron variant could be expected to push back the expected hike timelines by global central banks. Accompanying declines in oil prices can help to ease inflation worries that had recently underpinned global rates sell-off pressures. From a regional perspective, for Asia's exporters like China and South Korea, a pause in the shift from global goods demand to services demand will help to support Asia exports strength for longer. For Asian economies that typically run current account deficits such as Philippines and India, we can expect some import compression to return and halt the recent re-opening trend of widening trade deficits. Therefore, on its own, the Omicron variant can in fact be positive for Asia bonds by delaying normalization on several fronts.

    However, Fed Chair Powell's change of tune on the transitory nature of inflation has come at an inopportune time for Emerging Markets, especially Asia. The combination of the Omicron spread and a more hawkish/close-to-hiking Fed will make the coming months quite challenging for Asia bonds. Historically, Asia bonds don't do well in a Fed hiking cycle, even if the hike cycle has been well priced in by markets. Asia’s recovery to pre-pandemic trend growth path has been weaker relative to the US, largely a result of lower COVID-tolerance and harsher restrictions. And now with possible complications from Omicron, we don’t expect Asia to close the growth gap anytime soon. With growth on a weaker footing and inflation much more benign in Asia, it is also unclear if Asia central banks would be keen to match the Fed on pace and quantum of tightening. Therefore, assuming that the Fed completes taper in 1Q and hikes could start soon after, Asia is likely to enter into a Fed hiking cycle from a position of weakness. We note that Asia bonds have been resilient since Chair Powell’s comments, but we don’t think that is going to last.

    Duncan Tan

    Rates Strategist - Asia
    [email protected]

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