(Bloomberg) — The old playbook for selling emerging market bonds when Treasury yields are rising is being upended by the positive dynamics that favor developing country debt.
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Emerging bonds denominated in local currencies have extended this year’s rally – even as Treasuries have fallen – amid growing expectations of interest rate cuts and optimism about a soft landing for the global economy. A Bloomberg study showed that the correlation between emerging returns and US returns has fallen to almost zero.
“The deinflation process in emerging markets is proceeding faster than we previously anticipated — and this should allow central banks in emerging markets to cut interest rates sooner and faster than those in developed markets. . “We continue to overweight emerging market local currency bonds.”
While the Fed and many of its peers from developed countries have left the door open for further interest rate hikes, some of their peers in emerging markets have already begun to lower borrowing costs.
Chile’s central bank cut its key interest rate by 100 basis points more than expected last month, a decision that sent two-year bond yields lower on the following trading day. Policymakers in Brazil trimmed their benchmark index by 50 basis points more than expected on August 2nd.
The consensus on interest rate cuts in Latin America indicates that markets have not yet determined the full extent of potential easing.
Elsewhere, Hungary’s central bank cut its key interest rate last month for the third time in a row, while policy easing is also being discussed in Poland and the Czech Republic.
Growing optimism that the Fed will be able to handle inflation without triggering a recession, it favors emerging market bonds more than their developed peers.
“Higher bond yields in developed markets indicate less likelihood of a global recession,” said Rajeev de Melo, global macro portfolio manager at Gama Asset Management SA in Geneva. “I expect more resilient global growth to be the dominant force for emerging market assets.”
The above factors help explain why the link between emerging market bonds and Treasuries has broken down. The 30-day correlation between US 10-year yields and the Bloomberg Emerging Markets Local Currency Bond Index has fallen to around 0.1, according to an analysis by Bloomberg, with zero indicating no correlation. When US returns rose in February, the correlation increased to 0.57, while in March to June 2022, it was 0.61.
The slowdown in China is also positive for broader emerging market bonds.
Recent data from the world’s second-largest economy added to signs its recovery from the pandemic has faltered. Exports fell in July by the most in more than three years, while both consumer and producer prices fell last month, the first time this has happened since 2020.
The collapse in Chinese export prices and a weaker yuan mean the country is essentially “exporting inflation” to its trading partners in Asia, especially in Southeast Asia, and that “on the margins, is positive for both bonds and equities” in the region, said Cy Pictet.
Among the biggest downsides facing emerging market bonds is the appreciation of the dollar, which will reduce asset returns in the local currency.
Dollar strength led by the hawkish Fed pushed the MSCI Emerging Markets Currency Index up 1.5% in August, on track for its biggest monthly loss since February.
However, “the dollar appears overvalued across a range of valuation metrics, and is not a headwind for emerging market local currency bonds, making it likely that masked carry will resume its role as a major driver of returns,” Grant Webster, fund manager at Ninety One UK Ltd. in London, he wrote in a note to a client published on Tuesday.
Buyers back off
Even if emerging market bonds decline, any losses could be seen as a buying opportunity given the many positives.
Rowe Price, head of emerging markets fixed income at T. Rowe Price, said in an interview that the best time to buy EM debt is during generalized selling due to risk aversion associated with something else, as in March with US regional banks. in Melbourne.
The relationship between emerging markets and US bonds has deteriorated
what do you want to watch
India, Poland and Argentina will release inflation figures for July this week
China will release figures for industrial production, retail sales and fixed asset investment which may support the case for more stimulus
Philippine policy makers will announce the interest rate decision on Thursday
GDP data from Malaysia, Taiwan, Colombia, Hungary, Poland and Chile
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