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The Search for Yield, Emerging Markets, and a Wacky Divergence By Shah Gilani

Let's talk a little more about divergence - as in wacky divergences. Last time, we looked at divergence through the lens of interest rates and how rates - principally measured by the yield on the U.S. Treasury 10-year note - were going lower when they were expected to move higher as the Federal Reserve tapers its monthly bond purchases. But there's another divergence at work, and it strikes me as dangerous. The post The Search for Yield, Emerging Markets, and a Wacky Divergence appeared first on Money Morning - Only the News You Can Profit From .

Let's talk a little more about divergence - as in wacky divergences - and emerging markets.

Last time out, we looked at divergence through the lens of interest rates and how rates - principally measured by the yield on the U.S. Treasury 10-year note - were going lower when they were widely expected to start moving higher as the U.S. Federal Reserve tapers its monthly bond purchases.

We also noted that stocks were moving higher in the face of falling interest rates, whereas falling rates generally signal slackening in the economy and less demand for money.

Some wacky divergences, indeed.

Title: emerging markets - Description: emerging markets

But there's another divergence at work in this whirlpool of divergences, and it strikes me as not only wacky, but dangerous, if you're piling on.

I'm talking about the rising prices of emerging markets stocks and bonds.

Before I get to emerging markets, let me give you some relative background, the kind of background you need to piece together to make sense of this whirlwind of wackiness.

Here's what you need to know...

Treasury Holdings Are Up, Yields Are Down

According to the Federal Deposit Insurance Corp. (FDIC), the collective holdings of Treasurys by U.S. banks in the first quarter of 2014 rose 23%, a record that exceeds their holdings back in 1997 - and that's after adjusting for inflation.

One explanation for the drop in Treasury yields has been that banks were short Treasurys, expecting their yields to rise. When Treasurys rallied instead, the theory says banks scrambled to cover their shorts, as did a lot of other institutions that shorted bonds. But banks covering their short positions doesn't explain why their inventories grew so much.

If you're short and you cover, you are "flat," meaning you have no position. So the fact that banks added hugely to their Treasury bond inventories has nothing to do with rates falling on account of banks buying to cover shorts.

It has a lot to do with the fact that banks are still taking in lots of deposits (they were up 1.1% in the quarter) and are not making commensurately more loans. Loan growth for the quarter was up only 0.5%. The excess went toward buying Treasurys.

But that alone doesn't explain their increased holdings - there's still more to the story.

Banks' trading operations and mortgage-making profits are down, which resulted in a 7.6% drop in net profits for the quarter, according to the FDIC. The drop is just the second time in 19 quarters that America's 6,730 commercial and savings banks looked at reported year-over-year earnings declines.

Putting these pieces together, it's obvious that there's not an overwhelming demand for money, and banks are parking their excess reserves into Treasurys.

It looks to me like there's a widespread anticipation that rates will go lower. And given that today's second look at first-quarter gross domestic product (GDP) showed a negative 1% annualized growth trajectory, betting that the economy is soft makes sense.

What doesn't make sense is the divergence or upward path of emerging markets stock and bond prices.

A Capital Wave Is Flowing into Emerging Markets

Low bond yields in the United States, Europe, and Japan are causing a capital wave of money into emerging market stocks and bonds. Money is rushing into markets from Brazil and India to Indonesia and South Africa, surprisingly into all the markets that suffered big losses as recently as this past winter.

In places like India, business-friendly leaders are coming to power, and markets have risen largely on hope. But in Thailand, one of the best-performing markets in Asia this year, a military coup last week barely ruffled markets.

Throwing caution to the wind and hope into the mix, money is flowing back into emerging markets at the fastest pace in more than a year.

According to EPFR Global, from April through May 26, emerging markets-oriented mutual funds and exchange-traded funds added a net $13.2 billion on the heels of 10 straight months of net selling.

The Wall Street Journal this morning noted, "Some of the world's best performers this year are members of the so-called fragile five, countries that have been seen over the past year as especially vulnerable to the end of central-bank stimulus." India's market is up 16% this year, Indonesia is up 17%, and Brazil's main index has risen more than 16% in just over two months. Even Russian stocks have rallied.

What's even more frightening to conservative investors is that after interest rates in the strongest developed markets unexpectedly fell this year, emerging market yields and bond yields on Europe's PIIGS (Portugal, Italy, Ireland, Greece, and Spain) also fell.

It's a global hunt for yield.

Watch Out for "Massively Distorted" Yields

In the United States, junk bond yields are down to near their lowest levels on record, which by comparison makes emerging markets' bonds - like Brazil's benchmark 10-year bond, yielding 12.4%, and South Africa's 8.1% yields - look enticing.

But according to Gary Herbert, of $46 billion Brandywine Global Investment Management, "When you look at these yields, they are just massively distorted."

Emerging-market governments have issued $63 billion in debt, on pace to tie the previous record, set in 2012, according to Dealogic.

"The move into emerging-market currencies, stocks and bonds marks a reversal of outflows of $60 billion in early 2014 that resulted from increasing political tensions in Turkey and worries that some countries had grown dependent on the flood of cash generated by central-bank stimulus," the WSJ says.

Investors seem to be looking past China's slowing growth and data showing Indonesia's economy grew 5.2% in the first quarter, its slowest pace in four years. Indian growth has slowed considerably, while inflation is above 8%.

James Barrineau, an emerging-markets portfolio manager with Schroders plc, was recently quoted saying, "There's no relationship to fundamentals. It's all a search for yield."

Investor divergence back into markets they've only recently shunned is worrisome. Basing capital allocation on where the best returns are regardless of the obvious inherent risks, in the face of rising stock and bond markets in a global rotation trade, seems more like an accident waiting to happen.

Maybe I'm wrong. Maybe these divergences are sensible, maybe even enlightened. But then again, divergences are divergences for a reason.

We'll see.

More from Shah Gilani: There's more trouble ahead with the housing market, especially homeowners who took out HELOCs - which is why we're making these trades now...

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The post The Search for Yield, Emerging Markets, and a Wacky Divergence appeared first on Money Morning - Only the News You Can Profit From.

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