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The global macro backdrop has certainly gotten much more challenging for Asia rates and bonds. Fed and other DM central banks, primarily focused on curbing high inflation, are turning incrementally more hawkish and continue to deliver outsized rate hikes. Besides the resultant vol and further repricing higher of terminal US/core rates, the broad US dollar remains supported on larger downside growth risks in other major economies and geopolitics (escalation in Russia-Ukraine). Global liquidity and financial conditions are also firmly on tightening trends as DM central banks reverse pandemic-driven balance sheet expansion and outlook for other asset classes (equities/credit) are subdued.

Against this unfavourable macro backdrop, Asia rates and bonds cannot be expected to deliver positive absolute returns. However, we think Asia rates and bonds can continue to outperform G10 and other parts of EM, on a relative basis. As such, there would be opportunities for cross-market ideas between Asia and G10.

The basis of our outlook is the differences in central bank priorities and inflation processes between Asia and G10. Asia central banks generally are placing larger decision weights on downside growth risks and therefore are unlikely to match the outsized rate hikes in US/DM. Compared to US/DM, Asia inflation is also lower and less driven by demand-pull impulses. In fact, recent Asia inflation prints are moderating (largely due to lower energy prices) and surprising to the downside relative to survey. Therefore, even if US/core rates reprice even higher from here, Asia rates would follow higher but should be expected to rise by a smaller extent.

Asia central banks' FX policies are also supportive for Asia bond outperformance. Though Asia FX reserves have been significantly drawn down this year, there is still sufficient buffer in the near-term (in terms of reserves adequacy) for Asia central banks to continue to intervene to slow FX depreciation.

While we think Asia rates and bonds would outperform, the time window is likely to be short (1-3 months). All else equal, Asia's outperformance would imply that Asia-US rate differentials stay compressed relative to historical and Asia bond valuations further deteriorate relative to US Treasuries. At some point, Asia bond valuations could get so stretched (expensive) that it would be tough to justify continued outperformance, especially if global financial conditions get more stressed and EM risk premium widens from here. Therefore, this has to be a dynamic view.

Takeaways

Differences in central bank priorities and inflation drivers continue to support the outperformance of Asia rates and bonds. There are opportunities to receive/long selected Asia rates vs pay US rates. The key risks to our view are much tighter global financial conditions and more disorderly depreciation in Asia FX, which could cause Asia risk premia to widen.

Bond and Equity Flows

Foreign outflow pressures from China CGBs have eased, with August seeing a small USD0.3bn increase in foreign holdings. That said, large inflows are unlikely to return as long as growth recovery sentiments stay depressed. CGB yields would also need to be more competitive relative to US/core bonds, so as to incentivize money managers to hold more of it as a diversifier/hedge in global bond portfolios. Offshore continues to sell policy bank bonds (PBB), likely due to deeper liquidity and some worries of larger PBB issuances on the back of policy support measures.

For Asia ex China treasury/central bank bonds, recent net flow sizes are not particularly large. Of note, foreign buying of South Korea MSB/KTBs, which is usually quite consistent in the past, seems to be dwindling. August's USD0.6bn increase in foreign KTB holdings was the lowest in 20 months. We think foreign investors are staying away recently because of Korea rates' higher beta/sensitivity to surging US rates.

While foreign inflows into Asia treasury bonds are likely to remain subdued, we think offshore wouldn't be overly bearish on Asia bonds and the risks of large outflows is low. In terms of price impact, the lack of foreign bond inflows doesn't necessarily mean that Asia bonds need to cheapen or sell off. Since the onset of the pandemic, we have seen Asia bond markets shift to being more reliant on local bond demand and less on foreign bond demand. I.e. Local investors have become more influential marginal drivers of bond price.

In Asia equities, August inflows have reversed into outflows in September. India and Indonesia equities are the exceptions, with both seeing some net foreign purchases in September.

Fund Positioning

Fund managers' underweight positioning across Asia duration and Asia FX were relatively unchanged in August. The only notable move was in THB FX, where managers cut their underweights by almost 1% relative to July, presumably on recent positive data around improving tourist arrivals. From a portfolio perspective, the favoured strategy appears to be going underweight on China and Thailand exposures and maintaining largely neutral exposures to other major EM markets. Between EM duration vs EM FX, fund managers are more bearish EM FX.

Bond Valuations

Asia bond valuations are certainly not cheap. Our ARVI indicator suggest that Asia bond yields (ex South Korea) should be higher relative to US Treasury yields, to compensate for the deteriorating trend of Asia current account balances. Our Yield Decomposition approach suggest that 10Y Asia bond yields (ex Indonesia) do not offer a positive excess risk premia, to compensate for the various bond-related risks.

Ultimately, the sharp increase in 10Y US Treasury yields over August and September (nominal by 100bps, real by 120bps), together with Asia yields lagging US's rise, sets a very high hurdle for Asia bonds to be considered attractive. As to what could trigger a cheapening in Asia bonds, we likely need much tighter global financial conditions (severe risk-off) and more disorderly depreciation in Asia FX, for Asia risk premia to widen and Asia bonds to underperform.

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Duncan Tan

Rates Strategist - Asia

[email protected]

Eugene Leow

Senior Rates Strategist - G3 & Asia

[email protected]