Wednesday, November 2, 2011

Emerging countries and US financial markets

FT Alphaville reads a UBS report showing that emerging markets and the G3(US, Europe, Japan), have highly correlated financial data. The first graph shows the long term bond yield spread over short-term interbank rates in both groups

They point out that the macro data are highly correlated in terms of rates of growth(e.g. inflation or real GDP growth). 

I am currently writing a paper with an awesome coauthor on the impact of some political shocks on emerging markets' bond spreads over US Treasuries. One part of the paper looks at the determinants of emerging market spreads. When you consider "global" variables, such as the 3-month swap rate or the rate on corporate BAA bonds(sometimes seen as good substitutes for emerging market bonds), the fit is quite amazing. Below, I show results of some regression of EMBI spreads(emerging bond market index by country, from JPMorgan) on long term and short term treasury yields, corporate BAA bond spreads and the 5-year swap rate, a commodity index and a volatility index. Each column is a country at a different date(note the small number of observations in the first column). The fit is quite impressive.



The high explanatory variables of global/US(yeah, global=american, haven't you heard of the World Series?) is definitely not new. Uribe and Yue(2006) find that variations in US spread, along with innovations to country spreads(i.e. shocks to local bond yields) explain 85% of the variation in specific country spreads. They argue:
Most of this fraction, about 60% points, is attributed to country-spread shocks. This last result concurs with Eichengreen and Mody (2000), who interpret this finding as suggesting that arbitrary revisions in investors sentiments play a significant role in explaining the behavior of country spreads.
Hund and Lesmond(2008) report that "Conversations with emerging market bond dealers and hedge fund managers confi rms that it is not uncommon for them to hedge their risk in US equity markets, most usually the liquid S&P 500 futures market, but occasionally in the more volatile NASDAQ market", which might explain the correlation.

I feel that it is quite understandable why bond spreads or stock markets are highly correlated in the two groups, if we assume that investors have an international strategy and capital flows can move easily from one investment to another. It is more puzzling to see the high aggregate correlation in the UBS report in GDP growth:



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