Treasury correlation puts Malaysia at higher taper risk

Treasury correlation puts Malaysia at higher taper risk

4:38am EST

By Jongwoo Cheon

SINGAPORE (Reuters) – Record-high correlations between U.S. Treasury yields and the Malaysian and Thai currencies and high levels of foreign investment in their bond markets mean they could be hit hard when the U.S. Federal Reserve tapers quantitative easing. This focus on Malaysia and Thailand is in clear contrast from the May to September sell-off in Asian markets, when fear of the Fed tapering its stimulus drive hit the Indian rupee and Indonesian rupiah hardest because of their wide current account deficits.As U.S. yields rise in anticipation of policy tightening, money will flow out of Asian markets again, but the gap between the best and worst regional currencies will be less extreme than during May to September, analysts said.

“I would put that down to a combination of lighter positioning, less expensive valuations, and improved fundamentals, especially among the more vulnerable of the region’s markets,” said Sameer Goel, head of Asian rates and currency research at Deutsche Bank in Singapore.

Investors have differentiated between Asia’s emerging markets since mid-year, with the perceived safety and growth potential of Malaysia and Thailand drawing huge amounts of foreign capital into their bond markets.

Ironically, the simple fact that they have done well enough to attract that foreign investment now makes them vulnerable to the money leaving, even though neither country is battling the current account deficits nor structural problems afflicting India and Indonesia.

Foreigners hold 28 percent of outstanding government bonds in Malaysia. The country saw a net $1.1 billion of inflows into its bonds in the first nine months of the year, according to BNP Paribas, and total foreign ownership there amounts for half the country’s currency reserves.

In contrast, India has already suffered $8.7 billion in outflows from its bond market this year. This makes it a less-likely candidate for further hot money outflows, even though correlation of the rupee and Treasuries is high.

So Deutsche Bank, for example, is neutrally positioned on the rupee but short the ringgit because of the potential for outflows from the Malaysian bond market, said Deutsche Bank’s Goel.

“The correlation for now seems to be working more through the debt-sensitivity channel,” he said.

The Malaysian ringgit, Thai baht, Philippine peso and Singapore dollar stand out, with their monthly correlation with 2-year Treasuries at record highs. Correlations of the Indonesian rupiah and Indian rupee with Treasuries are high, but lower than they were in 2008.

The dollar tends to rise in line with U.S. Treasury yields, putting pressure on emerging market currencies, inversely correlating those currencies to Treasury yields.

When the Fed starts tapering five years of quantitative easing, the pain will still be pretty broadly distributed, as the selloff between May and September showed. Then, the rupee fell 12.5 percent against the dollar, Indonesia’s rupiah 15 percent and the ringgit 7 percent.

GOOD, BAD AND UGLY

Saktiandi Supaat, a strategist at Maybank in Singapore, there were strong economic linkages between the countries that raised the risk of the currencies affecting each other.

“The association between them suggests that some low-level contagion may still happen,” he noted.

Expectations for the timing of the Fed’s exit from quantitative easing have swung wildly in recent weeks, driven among other things by jobs data and the arrival of a dovish new Fed Chair in Janet Yellen.

Treasury yields have climbed in anticipation of a Fed taper by December, with 2-year yields up 10 basis points since May. At the same time, assurances from Fed officials that rates will remain low for a while could provide Asian currencies with some respite by ensuring local bond yields stay anchored.

BofA Merrill Lynch, however, notes India and Indonesia also have the highest correlations between sovereign credit risk and currency weakness.

That means India and Indonesia will be “ugly” when the Fed begins tapering, while Malaysia and Thailand would be “bad”, and South Korea and China are unlikely to be hit, they said.