Investors hope US rate cuts will provide lift for emerging market debt

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The US Federal Reserve’s jumbo interest rate cut is likely to ease the pressure on indebted emerging markets and fire up demand for local currency bonds after a drab period of returns, say investors.

Central banks, including those in South Africa, Turkey and Indonesia, have lowered their own policy rates or made dovish hints this week, as the first reduction in US rates in four years potentially ushers in the end of a dollar dominance that has rocked their economies.

Investors now hope that lower US rates, plus a potential “soft landing” in which the American economy avoids a recession that would have dragged down developing nations, will help attract money back into emerging market debt.

“We seem to be in a sweet spot where we’re not super-worried about US inflation any more, [but nor is it] that the US economy needs floating off the rocks,” said Paul McNamara, an emerging market debt portfolio manager at GAM. “That is positive for emerging markets.”

Lower US rates usually weigh on the dollar and push investors into riskier assets with higher yields, boosting emerging market currencies and making it easier for developing countries to repay debt denominated in the greenback.

Markets are currently pricing in more than seven quarter-point rate cuts by the Fed over the coming year.

Emerging market specialists are hopeful that this new era will help local-currency bonds, in particular, outperform over the coming months as central banks find themselves with more space to cut their own base rates.

“Central banks in emerging markets have more room to respond to their local inflation profile and ease more than they otherwise would have,” said Christian Keller, head of economics research at Barclays.

Many emerging markets were also quicker to raise rates than developed economies when global inflation surged, leaving them in a better position as the Fed now switches to easing.

Against this backdrop, the South African Reserve Bank cut interest rates also for the first time in four years on Thursday, by 0.25 percentage points to 8 per cent, from their highest levels in nearly two decades in real terms. And Indonesia also announced a surprise cut this week.

Even Turkey’s central bank, which has been fighting double-digit inflation with interest rates of 50 per cent this year, dropped a key reference to a need for further tightening in its latest monetary policy statement on Thursday.

“We now expect most emerging market central banks to cut much less than the US, either because they never needed to hike as much to re-anchor inflation towards target . . . or they are in the more advanced stages of their easing cycle,” Citi analysts said.

Emerging market debt denominated in local currencies has been a lacklustre corner of global bond markets so far this year.

A benchmark JPMorgan index for the debt has risen just under 4 per cent this year, lagging a dollar version which is up more than 8 per cent.

Many local currency bonds have rallied since the Fed signalled a shift in rates last month — with chair Jay Powell saying in his Jackson Hole speech that “the time has come” for rate cuts.

However, Pradeep Kumar, an emerging market portfolio manager at PGIM, acknowledged that investors had been put off by a series of unforeseen factors.

“Emerging markets have been pretty attractive this year from a valuation perspective but the sentiment has not been great,” he said.

Some emerging markets were hit last month by global market volatility that curbed a years-long trade to borrow in yen at low rates and buy high-yielding debt such as Mexican peso bonds and those denominated in the Brazilian real. Those sharply unwound last month as the Japanese currency rallied and the emerging market currencies depreciated.

Demand for Mexican bonds also fell after the country’s ruling party secured support for radical constitutional changes in which judges will be elected, a move that investors fear will undermine the rule of law.

Brazilian debt has also sold off this year as markets worried about the fiscal commitments of Luiz Inácio Lula da Silva’s government. Amid rising inflation and growth forecasts, Brazil’s central bank — the BCB — went in the opposite direction and raised interest rates for the first time in two years. The quarter-point increase took its benchmark to 10.75 per cent.

“The combination of the Fed rate cut and a hike by the BCB, with both signalling that they are likely to continue to move in their respective directions in coming months, is most obviously supportive for the Brazilian currency, the real,” said Graham Stock, emerging market strategist at RBC BlueBay Asset Management.

South Africa has long been overshadowed by potential political instability but Robert Simpson, senior investment manager at Pictet Asset Management, said that a change in the make-up of the government was removing some of the risk associated with South African debt. He added that there was an expectation that total returns would increase in line with a rate-cutting cycle.

That catalogue of issues, combined with the US presidential election, are still keeping some investors cautious. A victory for Donald Trump in November may result in a round of trade tariffs that could reduce US demand for imports, strengthen the dollar and weaken emerging market economies and currencies that rely on cross-border trade.

“There was a time in the wake of the global financial crisis where if the Fed cut, investors could buy with their eyes closed. You’ve got to be more selective,” said Kumar.