EM Central Banks Lead the Way on Tightening. Bond Investors Are Waiting for Next Year.

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Looking to yield in a world of diminishing returns? How about Brazil? The central bank there raised interest rates from 2% to 7.75% this year, and 10-year local-currency bonds yield north of 11% annually. Mexican rates have risen from 4% to 5% since May. Poland rose from 0.1% to 1.5% in the past two months. And so on.

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“This is the first time in 35 years that I’ve seen EM central banks continue on a path of strength,” says David Robbins, emerging markets debt portfolio manager at TCW.

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He and other managers aren’t depositing in bonds yet, though. Maybe next year. The iShares JP Morgan EM Local Currency Bond Exchange-Traded Fund (ticker: LEMB) is down more than 7% since September 1, a vertical decline for fixed-income funds.

Other things being equal, a widening gap between US and foreign interest rates should rekindle the so-called carry trade: investors borrow in dollars (or euros) and redeploy in reals, pesos, or zlotys. But other things are far from equal as the world struggles to emerge from Covid-19 without reigniting runaway inflation.

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Emerging market rate hikes barely keep pace with price increases, and inflation there looks more difficult than in developed markets. US and Mexican inflation are both currently around 6%. A year from now, the market projects the US at 2.5%, while Mexico is stuck at 4.5%, says Phoenix Cullen, head of emerging markets research at Societe Generale. It lowers expectations of return.

Instead investors are emphasizing the downside for emerging markets. The Federal Reserve signaled a strengthening of the dollar and sparked memories of the “taper tantrum” that crashed emerging markets in 2013. “This whole year has been a taper tantrum in the fit and the beginning,” says Cullen.

Even the most aggressively hiking countries run long hours at political risk. Brazil faces a choice next year between two bad choices from a market perspective: incumbent President Jair Bolsonaro and leftist former president Luiz Inácio Lula da Silva.

The peso fell to an eight-month low this week as Mexican President Andres Manuel López Obrador’s out-of-left-field choice for governor of the central bank.

And Russia was a capital magnet on rate hoaxiness and energy prices for much of this year. Now it is faltering as Vladimir Putin has pooled forces against Ukraine. The ruble is down 8% against the dollar over the past month, burning bondholders.

Asia is offering less immediate risk and less reward. Regional giants India, Indonesia and the Philippines all held steady near record-low interest rates.

Next year may be better, investors say, as inflation cools and emerging market interest rates peak, just as the Fed begins to hike interest rates for real. Rising rates are the enemy of bondholders. “Once we see extreme inflation, the carry trade could come back with force,” says Luc D’Huge, head of emerging markets bonds at Vontobel.‘s
Fixed Income Boutique.

D’Huge is expecting that happy moment in the spring of 2022, which is an educated guess. Another precondition: a continued cooling of US economic growth – the third quarter rate was 2.1% year-on-year – while emerging markets emerge out of the pandemic. “People like to see the development gap with the developed world growing, not shrinking, as it has been,” says D’Hoge.

If many. “It may be darkest before dawn,” says SokGen’s Kallen. Or the night could last a little longer.


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