Bond market opportunities in emerging countries

Pradeep Kumar June 21, 2023 09:42

As the third year of central bank tightening continues, the difficulty in identifying the peak in policy rates has emerged as one of the cycle's prominent hallmarks. However, several factors point to a deceleration in emerging market (EM) inflation, placing many EM central banks in the area of peak rates. As markets price in central bank holding patterns and eventual rate cuts, the question shifts to the breadth of the investment opportunities in local rates markets.

Given the sudden onset of inflation, EM central banks led a wave of policy tightening. In addition to a moderation in commodity prices, the benefit of their proactive approach is readily apparent as base-year effects take hold and tradable goods inflation slides while non-tradable services inflation slows a more gradual pace with headline and core inflation materially decelerating in most EM economies.

Yet, the evolving EM inflation backdrop raises the question of where central bank policy rates are headed, when they might do so, and the respective investment implications.

Rate Cut Prospects

Following the crescendo of EM central bank rate hikes in May 2022, it is not surprising that markets priced in rate cuts over the coming months through the next two years. For the EM central banks that started hiking as early as the second half of 2021 or early 2022, the timing and number of cuts that are priced in varies across countries. The market pricing for cuts generally depends on the starting point of the hiking cycle, the cumulative hikes thus far, as well as the dynamics around the long-term neutral policy rate.

Furthermore, with 225 bps of rate cuts priced in for the US Federal Reserve over the next two years, potential easing in US policy could further deflate some of the strength in the US dollar while alleviating downward pressure on EM currencies, providing another source of disinflation and policy-rate relief across emerging markets.

The Prior, Post-GFC Hiking Cycle

Viewing the market's expectations for rate cuts from multi-decade highs in comparison to prior, post-GFC rate cycles provides context regarding the potential time between the last hike and first rate cut as well as the total amount of easing. From a broad, historical perspective, once the policy rate is kept at sufficiently restrictive level for an extended period, the next move is generally the start of an aggressive easing cycle.

It is very common for EM central banks to keep rates elevated for six to 12 months (or even longer) before starting an easing cycle. In addition, the higher the policy rate relative to country's long-term neutral rate and the longer central bank's pause, the bigger the easing cycle. In most cases, the scale of monetary easing has been at least 50% of the cumulative hikes.

For example, Thailand was on hold for only two months in 2011 before cutting its base rate by 200 bps to 1.5%, but South Korea kept its base rate at 3.25% for almost 12 months after hiking by 125 bps in 2010-11, and it later slashed the rate by 75 bps.

When the historical precedent to current conditions is extrapolated, the rate cuts priced into local yield curves in Latin America and CEEMEA have plenty of additional room to potentially adjust lower over a longer period of time, as concerns about decelerating growth mount. This underscores the momentum behind the asset class and the rationale for long-duration positioning. The subsequent issue becomes identifying which curves may be appropriate for long-duration exposure.

Current Hiking Cycle

When shifting to the current cycle, countries that were the earliest to tighten, the earliest to pause, or that implemented large scale rate hikes may be candidates for long-duration positioning. Hence, the long duration positioning in such countries not only offers the potential for positive real yields as inflation pressures recede, but they also present the possibility for attractive total returns as yields drop in response to policy rate cuts.

Compared to Latin America and CE-3, many Asian countries were less affected by the global surge in inflation amid China's more moderate-than-expected reopening and lingering concerns about its real-estate sector. The disinflation spillover from China will likely influence certain monetary policies in the region, such as those for Indonesia, South Korea and Thailand.

In that context however, South Korea was an exception in the Asia region. Since 2021, Bank of Korea hiked the policy rate by 300 bps to 3.5%, a post GFC high. With only 50 bps priced in the curve for the next two years, the risk-reward favors owning the belly of the interest-rate swaps curve. Indonesia was a shining star during the current hiking cycle, and due to its favorable term of trades and sluggish domestic demand, Bank of Indonesia hiked only 225 bps to 5.75%. As such, we remain constructive on local bonds in Indonesia and a potential rate cut in the second half of 2023 will provide an additional impetus to a long-term structural story.

Conversely, Malaysia, a relatively late and slow hiker, recently surprised the market by hiking in May. As a result, optimal positioning in late and slow hikers may be more focused on underweighting duration at the front end of their curves. Thailand is somewhat a similar story. The Bank of Thailand hiked its policy rate to 2% in May, and while the local Thai yield curve is steep, its low levels of yields relative to its peers is a big deterrent to further yield compression even if its hiking cycle is ended.

The post-Covid landscape for investing in EM local rates has been one of flexibility, and EM central banks' leadership in tightening monetary policy initially warranted short-duration positioning at the front of yield curves. From an inflation perspective, the proactive approach to hiking rates appears to be benefitting the respective countries as inflation finally moderates. As we view the landscape for the potential scale of rate cuts, we see the opportunity for long positioning in several countries that appear to have ample room to loosen policy. However, further allocation considerations include the critical role of carry and rolling down yield curves in terms of identifying the opportunities and momentum behind the EM local rate markets.

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Pradeep Kumar

Portfolio Manager, Emerging Markets Debt, PGIM Fixed Income