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A recent string of US labour, inflation and activity data are driving a shift in the outlook and market narrative - that US growth risks are not as severe as previously feared, the labour market could stay tight, and elevated inflation would require higher-for-longer Fed rates. Market implications include the ongoing repricing higher of Fed rate path, widening in term premium impacting long-term UST yields and mild recovery in the broad US Dollar.

From the perspective of Asia local markets, the increased uncertainty around Fed and near-term boost to the US Dollar are negatives for asset inflows and performance. Previously strong equity inflows into North Asia (China/Korea) and strong bond inflows into high-yielders (Indonesia/India) showed signs of slowing in February. Asia local market assets are also giving back a portion of the large positive returns between November and January. For our coverage area of Asia rates and bonds, we think the increased uncertainty around the Fed would warrant some paring back of risk, but not to turn outright bearish.

Looking at the breakdown of Asia bond returns in February, losses have largely been in currencies, rather than fixed income component. And we expect this trend to continue, while we await more clarity on Fed outlook.

At the start of the year, most market players and Asia central banks were likely expecting Fed rates to peak at 5.00 or 5.25%. We think that a potential shift in the base case by as much as 50bps to 5.75% is unlikely to significantly influence the policy stances or alter the rate paths of Asia central banks, because regional currencies have largely recovered from 2022's losses and the ongoing rally in the broad US Dollar is not as sharp as in 2Q-3Q of last year.

With the exception of BOT and PBOC, we expect Asia central banks to end their hike cycles by end-1Q or early-2Q, as the policy focus tilts back towards growth and local factors. The imminent pause in hike cycles would help to anchor Asia rates against rising US rates, especially at the front-end (up to 2Y or 3Y). For the back-end, such as 10Y Asia bond yields, the beta to US would be higher. But we expect upward pressures to be offset by improvements this year in bond supply-demand dynamics for several bond markets.

Therefore, in the near-term, we expect the risks from Fed uncertainty and higher US rates to be concentrated in the currency component of Asia bond returns.

Real money bond investors could consider tactically hedging out currency exposures of their bond holdings or buying Asia bonds on an asset-swapped to USD basis. This is especially as unhedged yield differentials vs UST are currently very compressed, and FX-hedged/asset-swap yields are much more attractive.

In the following sections, we write about some of our new ideas for specific Asia rates markets. At this end of this report, we also review our 2022 ideas and their performance.

1. Long 10Y KTB (hedge FX via 1M or 3M USDKRW NDF)

In our 2023 Annual Outlook, we favored an overweight stance on Korea Treasury Bonds (KTB) on the back of a deteriorating growth outlook weighed by exports and domestic demand. Now that the KRW has also recovered from its October lows, we expect Bank of Korea (BOK) to bring an end its hike cycle at the upcoming April meeting. The combination of weak growth dynamics and near-completion of BOK hike cycle would be strong anchors for KTB yields, against rising US rates. We also expect KTBs to be included into the WGBI Index at FTSE Russell's March review, with the phase-in process kicking-off in 4Q. There could be some front-running inflows in 1H which could see KTB yields narrow against KRW IRS rates. We think February's back-up in 10Y KTB yields to 3.60% provide a good re-entry to long 10Y KTBs, this time paired with a Buy 1M or 3M USDKRW NDF to cheaply hedge out the FX exposure.

2. 1Y-5Y CNY NDIRS steepener

1Y-5Y CNY NDIRS steepener is an idea that we like for 1H. The basis is that PBOC will maintain adequate and stable liquidity conditions that would hold down the 1Y, while further reopening/recovery progress would uplift the 5Y. However, 1Y-5Y had instead flattened in February because of tighter-than-expected liquidity conditions (due to heavy NCD maturities, loan growth) and paring back of recovery optimism (as reflected across risk-sensitive Chinese assets). Despite recent developments which go against our view, we maintain conviction and think that February's flattening provides a better entry point to put on 1Y-5Y CNY NDIRS steepener idea. In the coming days, we would expect PBOC to inject more liquidity to calm repo rates. We also think that recovery expectations would rebound ahead, especially with next month's National People's Congress where more growth-support measures could be announced.

3. Long 5Y IGB vs pay 5Y INR NDOIS

5Y bond-swap spreads in India appear to have peaked at around +100bps in January and have been tightening since. We think that the near-term outlook is for further tightening and like to long 5Y IGB vs pay 5Y INR NDOIS. Bond valuations are relatively cheap and valuation buffers would help to cushion against rising US rates. Near-term supply technicals are also favourable, as there will be no auctions after this week (auctions to resume in early-Apr). On the other hand, the risks to swap rates are tilted in the other direction - Upwards. RBI could maintain a hawkish stance for longer, due to worries around the stickiness of inflation. Current quarter inflation is tracking above RBI's forecast and poses upside risks to RBI's rate path. We think OIS markets could price in as much as a couple more rate hikes for this cycle, and 1Y-5Y OIS curve could steepen if markets expect sticky inflation to persist.

Review of 2022 Asia Rates Ideas

In 2022, we initiated a total of 20 Asia rates ideas, of which 12 worked out (11, if adjusted for carry/roll). Aggregate performance was +167bps (+146bps, if adjusted for carry/roll). Because of the large movements in rates in 2022, we had purposefully set tighter stop-losses and wider take-profit points. As a results, gains on ideas that worked out were much larger than losses on ideas that failed.


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Duncan Tan

Rates Strategist - Asia

[email protected]

Eugene Leow

Senior Rates Strategist - G3 & Asia

[email protected]