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The New Cracks in Sovereign Debt

European electoral changes have dramatically altered risk sentiment in global markets


In my May 7 InvestorPlace article, “The Safest Way to Play Sovereign Debt,” I looked at the strength of emerging-market paper relative to nominal U.S. Treasuries, which were then yielding around 2%.

Given investors’ search for returns in a world where U.S. government bonds are yielding less than the Fed’s stated 2% inflation target, higher-yielding emerging-market debt has been receiving more attention.

I concluded that “the trend remains favorable for sovereign debt, given yields that are considerably higher than those of Treasuries. If 2012 is a year of reflation, as I’ve been arguing, Treasuries could continue to underperform emerging-market debt, on average, as long as contagion from Europe’s debt crisis does not hit smaller economies.”

Following that article, European electoral changes dramatically altered risk sentiment in global markets, as equities broke down precipitously. My company’s ATAC models sensed that a period of “mini-correction” was likely back in early April, as I had written, but the speed at which sentiment turned negative is alarming.

Last week there was a noticeable fear in the credit markets, as SPDR Barclays Capital High Yield Bond ETF (NYSEARCA:JNK) fell substantially relative to Treasuries, which rose. A dramatic credit event seems to be being priced in now in emerging-market debt as well.

Below is an updated price-ratio chart of the PowerShares Emerging Market Sovereign Debt ETF (NYSEARCA:PCY) relative to the iShares Barclays 7-10 Year Treasury Bond Fund (NYSEARCA:IEF). As a reminder, a rising price ratio means the numerator/PCY is outperforming (up more/down less) the denominator/IEF. A falling ratio means the opposite.

Notice the incredibly sharp break on the far right of the chart, which in its speed and magnitude is reminiscent of the May 6, 2010 Flash Crash period and the Summer Crash of 2011. (I discussed this on Bloomberg on Friday, May 18.)

Two weeks has left us with a meaningful credit-spread widening, which could be ominous if not reversed. If this ratio recovers, I believe the chances of continued reflation are high and stand by my overall bullish stance. However, if credit markets are indeed correct, an “event” may be upon us.                    Click to Enlarge

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