Asia Rally May Just Be ‘False Dawn’ as Fed Isn’t Done With Hikes

(Bloomberg) — Amid a broad Asia rally on expectations for a dovish shift from the Federal Reserve, some strategists warned the market reaction may be excessive.

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Asian bonds and currencies jumped on Friday amid rising hopes for a peak in US inflation. The won and baht led gains, with both currencies strengthening by more than 2% against the dollar, with the respective 10-year benchmark yields falling by at least 15 basis points. The rally may just be a “false dawn,” according to Mizuho Bank Ltd.

Markets may be in for a disappointment as the Fed is nowhere near to pausing its campaign of higher rates given still elevated inflation. Emerging-market assets rallied from end-July as investors wrongly perceived a dovish Fed pivot, only to give up gains following hawkish comments from FOMC members and from Fed Chair Jerome Powell at Jackson Hole. A loss of 1.1% in EM Asia local currency bonds in August deepened to over 4% in September, the worst monthly returns on record in data going back to 2008.

“My initial sense is that it does seem like an exaggerated exuberance owing to cautious positioning,” said Vishnu Varathan, head of economics and strategy at Mizuho Bank Ltd. in Singapore. My suspicion is that for a Fed that will “keep at it until the job is done,” and in so far that peak Fed Fund rates are still bound to drift higher, this narrowing of US-Asia inflation differentials would be less desirable for EM Asia assets, he adds.

Foreign bond inflows into Indonesia and Thai debt in August, the first in many months, were fully reversed as international investors pulled out in September and October.

“One day of retracement lower in Treasury yields is probably not enough to make local currency bonds appealing to foreign investors” said Frances Cheung, a Singapore-based rates strategist at Oversea-Chinese Banking Corp.

Following the US CPI report, Fed overnight indexed swaps are pricing virtually zero probability of a 75-basis point hike in December, which would be a step down from the four consecutive 75-basis point Fed rate hikes so far.

“Policy rates are still going higher in both the Fed and Asian central banks, so there might be limits to how far bonds can rally,” says Galvin Chia, EM FX strategist at Natwest markets in Singapore.