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Hawkish Flags Multiply as Emerging Market Bond Rally Faces Threat

June 16, 2024
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The era of dovish monetary policies that sparked a rally in emerging-market bonds seems to be ending as central banks in developing countries adopt more hawkish stances.

Returns from local-currency debt in emerging markets are lagging behind their dollar-denominated counterparts by the most in two years. This shift is due to rising inflation, which has dampened hopes for further interest-rate cuts in Latin America and Eastern Europe. Additionally, policymakers in emerging Asia are increasingly reluctant to ease policies ahead of the Federal Reserve.

"The easy money is definitely gone," said Robert Samson, a fund manager at Nikko Asset Management in Singapore, which managed $240 billion at the end of March. "Duration hasn’t really paid off with curve inversion and the Fed maintaining higher rates for longer."

This new hawkish approach is disrupting a strategy that was once seen as a "once-in-a-generation" opportunity to invest in emerging-market local debt. Investor enthusiasm has waned not only due to the fading prospects of rate cuts but also because a strengthening dollar is undermining developing-nation currencies.

Emerging-market local bonds have incurred a loss of about 1% this year, following a rally of over 6% in 2023, according to a Bloomberg index. In contrast, a similar index of dollar debt has delivered a 2.5% return since December.

Recent hawkish trends have surfaced as Brazil’s inflation exceeded expectations in May, and Mexico’s central bank highlighted persistent price pressures as a reason for caution in easing policy further. In Peru, policymakers unexpectedly halted rate cuts last week due to concerns about consumer prices.

In Europe, Hungary’s central bank indicated it is nearing the end of its easing cycle, while Poland’s government’s wage plan may delay rate cuts. In Asia, Thailand’s policymakers held rates steady last week after inflation accelerated, and Taiwan’s central bank increased the reserve requirement ratio for banks, tightening policy.

Federal Reserve Influence

The Federal Reserve’s "higher-for-longer" stance is reducing the scope for policy easing in emerging markets.

The Fed is a "significant headwind for progress in the second half," said Rajeev De Mello, a global macro portfolio manager at GAMA Asset Management in Singapore. "All central banks worldwide, even beyond emerging markets, were hoping the Fed would assist by sticking to its initial plans of cutting rates."

Growing hawkish signs are prompting investor sell-offs. The $2.7 billion VanEck JP Morgan EM Local Currency Bond ETF, the world’s largest ETF tracking developing-nation debt, has experienced net outflows over the past three months, according to Bloomberg data.

Re-Emerging Value

Despite the pullback, some see an opportunity to be bullish on local-currency bonds.

Value is resurfacing in emerging-market debt now that rate cuts are priced out, and political risks in Mexico and Brazil are accounted for, said Shamaila Khan, head of fixed income for emerging markets and Asia Pacific at UBS Asset Management in New York.

“It’s probably looking more attractive than it has over the last several months,” she said. “We believe the local space has the potential to perform well going into the end of this year, even if there’s only one or two rate cuts from the Fed.”

William Blair International Ltd. also sees value reappearing and is investing in frontier markets.

“We currently have between 12% and 15% in local frontier markets with a risk limit of 1% in each market, ensuring good diversification,” said Daniel Wood, a fund manager at William Blair in London, adding he favors countries like Kenya, Nigeria, and Pakistan. “You’re in the sweet spot now where you’re enjoying high carry with strong multilateral support.”

Slow Progress

Others, such as T. Rowe Price, suggest that investors may need to be patient before emerging-market local bonds resume their rally.

“Over the past 12 to 18 months, returns have been quite attractive,” said Leonard Kwan, a fund manager at T. Rowe Price in Hong Kong. “From here, some opportunities will slow down. You’ll earn some income in the meantime and then wait for the next phase, which may occur later this year or into the first half of next year.”

Adan Harris
Managing Editor
Eric Ng
John Liu
Editorial Board
Bryan Curtis
Adan Harris
Managing Editor
Cathy Hills
Associate Editor

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