Russia Choking Ruble Rally Sustains Bond Faith With Rates Pledge

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Russia has managed to wrench investors away from the world’s best currency trade without denting demand for its bonds.

While the central bank halted the ruble’s advance on Thursday by purchasing foreign currency for the first time since moving to a free-floating exchange rate in November, the government’s local debt extended the biggest gains in emerging markets this year.

The rally underscores bondholder confidence that the recovery in oil prices and reduced tension in Ukraine will enable Bank of Russia governor Elvira Nabiullina to reverse last year’s emergency interest-rate increase without stoking inflation. The ruble has strengthened 21 percent against the dollar this year, more than twice as much as any other currency.

“The central bank still has room to cut rates as long as the ruble behaves itself,” said Edwin Gutierrez, who helps oversee $13 billion at Aberdeen Asset Management Plc in London. Purchases of Russia’s so-called OFZs late last year and in the first quarter of 2015 helped Gutierrez’s Aberdeen Emerging Markets Debt Local Currency Fund outperform 70 percent of its peers this year. The ruble intervention isn’t a reason to exit from bonds, he said by e-mail Thursday.

The government’s 2027 ruble bond gained for a second day on Thursday. Its yield has plunged 2.7 percentage points in 2015, the biggest decline among 25 emerging-market nations’ securities tracked by Bloomberg.

Trader Expectations

After lifting interest rates 650 percentage points in December to stave off a plunge in the ruble, Nabiullina reduced the key rate three times totaling 450 basis points this year to 12.5 percent. The Bank of Russia stands ready to continue lowering the rate as inflation risks abate, policy makers said on April 30, the last time it enacted a cut.

Traders are expecting a 1 percentage-point rate reduction in the next three months. Still, that’s less than the 1.5 point reduction they’d anticipated earlier this month, according to prices for three-month forward rate agreements.

The currency weakened as much as 2.7 percent to 50.6370 per dollar on Thursday as the Bank of Russia said it would buy $100 million to $200 million a day in the market to replenish its cash pile, which tumbled to as low as $351 billion in April, the lowest since at least 2008. The ruble strengthened 1.4 percent at 2:55 p.m. in New York on Friday.

Elevated Volatility

The reserves started falling in July last year as policy makers sought to defend a currency weighed down by a rout in the price of oil and U.S. and European sanctions over the conflict in Ukraine. Russia spent almost $90 billion on interventions in 2014 before abandoning its managed exchange-rate policy in November.

For Barclays Plc and HSBC Holdings Plc, the rally in Russia’s local-currency bonds is driven by technical factors rather than fundamental reasons and will probably to reverse. Valuations are “broadly unattractive” and don’t reflect inflation and credit risks, HSBC’s Di Luo said in a note on May 7.

“Foreign exchange volatility is strikingly higher than in other high-yielding EM peers,” Luo, a London-based fixed-income strategist at HSBC, said. “We see little value in chasing Russian yields lower.”

Mixed Blessing

While the rally in the ruble has eased inflationary pressure, it’s also curtailed export earnings in local-currency terms as analysts project the budget deficit widened to 1 trillion rubles ($20 billion) in the first four months. The ruble’s three-month implied volatility, which reflects expectations for currency swings, was the highest in the world as of Thursday, according to data compiled by Bloomberg, raising the cost of hedging and making price moves harder to forecast.

Russian inflation ended an eight-month climb in April, decelerating for the first time since July. Year-over-year growth in consumer prices will probably slow to 5 percent in the next 18 months from the current level of 16.4 percent, Bank of America Corp. strategist David Hauner said in a research note on May 14. The decrease in inflation makes him bullish on Russia’s OFZ bonds longer term, he said.

The slowdown in inflation and the gains in the ruble will allow for more easing of monetary policy, reviving economic growth and benefiting investors, according to James Barrineau, co-head of emerging-market debt relative at Schroder Investment Management. He forecasts a reduction in borrowing costs of as much as 400 basis points before the end of this year if consumer prices keep falling.

“Yields are still in the low double digits, where else can you get these yields?” Barrineau said in an interview on May 6 in New York. “If you own local currency bonds, you can anticipate a fairly aggressive rate-cutting cycle from the central bank, so it’s still an attractive investment, still worth holding.”