The Next Leg of the Emerging-Bond Rally Is About to Start on Rate CutsBy , , and
Pressure on central banks points to more gains for EM debt
Dovish outlook on display in markets from Brazil to Russia
The bond rally across emerging markets may get fresh legs.
Pressure is growing on central banks in developing nations to cut interest rates more aggressively as inflation eases and the Federal Reserve takes a gradual approach to policy change. That’s reducing the need for the high borrowing costs that deter capital outflows and protect emerging-market currencies.
Looser monetary policy is a potential boon to already surging sovereign and corporate bonds in emerging markets, which in recent weeks revived a rally that sent both dollar-denominated and local-currency debt gauges to all-time highs.
“Now that inflation is coming down and currencies have stabilized, you are seeing the monetary policy in many emerging markets shifting toward an approach of lowering rates, or at least stabilizing rates,” which is good news for bonds, said Steven Oh, the global head of credit and fixed income at PineBridge Investments LLC.
This year, as many as 16 emerging-market currencies returned 5 percent or more to investors borrowing dollars and buying local assets, while the extra yield bondholders get for owning developing-nation sovereign notes rather than U.S. Treasuries is about a third higher than in 2013. To some analysts, that signals central banks are keeping rates too high.
“Emerging-market central banks have been overly cautious,” said Simon Quijano-Evans, a strategist at Legal & General Investment Management Ltd. in London. “They’re going to get a wake-up call when food and oil-price growth head into negative territory later this year.”
Policy makers from Brazil to South Africa have already started to cut rates, and others in places like India and Mexico are finding it increasingly difficult to stay hawkish.
Investors appear to be anticipating the policy shifts. Developing-nation bond funds received cumulative net inflows of at least $61 billion this year as they rushed to take advantage of higher yield spreads before the gap to U.S. rates narrows.
That’s because falling emerging-market rates, higher U.S. borrowing costs or a combination of the two would reduce the spread and hence the appeal of developing-nation carry trades. And if investor expectations for a weaker dollar and muted increases in Treasury yields change, that could also hit emerging currencies and the bond rally could unwind, Quijano-Evans said.
“The carry story will get a big hit if there’s a big pickup in the reflation story,” he said.
For now, slowing inflation is adding to the gains. A Citigroup index shows that emerging-market inflation reports are coming below estimates by the most since September. In India, 10-year sovereign yields fell 17 basis points as consumer-price growth more than halved in the three months through June. In Brazil, where inflation has slowed for 10 successive months, yields have dropped toward a four-year low. Russian yields have dropped 112 basis points since early November.
Here’s the outlook across key emerging nations:
The Latin American country is fighting to leave behind the worst economic recession in a century. The government is pushing for economic-policy changes and the central bank has reduced borrowing costs by 5 percentage points since October, taking the benchmark rate to single digit for the first time since late 2013.
Economists had expected policy makers to maintain the key rate at their July 20 meeting given that price growth remained close to the top of the target range and the currency looked vulnerable. But with an economy in recession and inflation at a 19-month low, the central bank was feeling the pinch of higher rates. Its surprise cut was welcomed by the market as the currency rebounded after initial losses. Real yields are still so high that the repo rate could fall another 75 basis points without hurting the rand, Citigroup Inc. said.
Rest of Africa
While Nigeria and Angola are combating high inflation, other African countries are turning dovish. Ghana has decreased its policy rate by 500 basis points since the beginning of November, helping to halve its three-month local-bond yields. Mozambique reduced rates in April for the first time since 2014, while Uganda and Malawi have also eased.
Consumer-price inflation hit a record low in June amid a lingering bad-loan problem and rising unemployment. That might push the Reserve Bank of India to opt for a 25 basis-point rate cut in August, according to IDFC Bank Ltd. The country is still recovering from a cash ban in November that dragged the economy to the slowest growth in two years.
Amid a slow economic recovery, Russia’s central-bank Governor Elvira Nabiullina has been vocal about her plan to cut rates. But after three reductions this year, she got a surprise when inflation unexpectedly jumped in June. While that may discourage another cut on July 28, she may resume easing later as core inflation remains below expectations.
Economists see the central bank starting to cut rates in the second half of 2018, although Governor Agustin Carstens maintains it’s too soon. The annual inflation rate fell in early July after a year of acceleration that pushed policy makers to raise borrowing costs.
Colombia’s falling inflation enabled the central bank to reduce the benchmark rate by two percentage points since December and the easing cycle looks likely to continue.
The central bank lowered borrowing costs in July for the second time in three months after trimming its growth and inflation forecasts amid a three-year investment slump. The reference rate, now at 3.75 percent, may be cut by another 25 basis points, according to economists.
Vietnam surprised economists this month with its first rate cut in three years, a day after the International Monetary Fund said the central bank should keep borrowing costs unchanged to contain rapid credit growth. The central bank said it was aiming to boost economic growth. Annual inflation eased in June to the slowest pace in almost a year.
— With assistance by Lyubov Pronina, Sid Verma, and Janine Wolf