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The US Federal Reserve’s sharp interest rate cut is expected to ease pressure on indebted emerging markets and boost demand for local currency bonds after a period of poor yields, investors say.
Central banks including those in South Africa, Turkey and Indonesia have cut their own policy rates or made more dovish hints this week, the first US rate cut in four years This potentially marks the end of a dollar dominance that has shaken their economies.
Investors are now hoping that lower U.S. rates, along with a possible “soft landing” in which the U.S. economy avoids a recession that would have dragged developing countries down in its wake, will help attract capital back into emerging market debt.
“We seem to be in a sweet spot where we’re not overly concerned about U.S. inflation, but we also don’t need to get the U.S. economy back on track,” said Paul McNamara, emerging markets debt portfolio manager at GAM. “That’s positive for emerging markets.”
Falling U.S. rates typically weigh on the dollar and push investors into riskier, higher-yielding assets, boosting emerging market currencies and making it easier for developing countries to repay their dollar-denominated debt.
Markets are currently pricing in more than seven quarter-point rate cuts from the Fed over the next year.
Emerging market experts hope the new era will help local currency bonds, in particular, outperform in the coming months as central banks find themselves with more room to cut their own base rates.
“Emerging market central banks have more room to respond to their local inflation profile and ease monetary policy more than they would otherwise have,” said Christian Keller, head of economic research at Barclays.
Many emerging markets were also quicker to raise rates than developed economies when global inflation soared, putting them in a better position as the Fed now shifts to easing.
In this context, the South African Reserve Bank reduce interest rates Interest rates also rose on Thursday for the first time in four years, by 0.25 percentage points to 8%, from their highest levels in nearly two decades in real terms. Indonesia also announced a surprise rate cut this week.
Even Turkey’s central bank, which is battling double-digit inflation with interest rates of 50% this year, dropped a key reference to the need for further monetary tightening. its latest monetary policy statement on Thursday.
“We now expect most emerging market central banks to cut rates much less than the U.S., either because they have never needed to raise rates as much to re-anchor inflation toward target… or because they are in the more advanced stages of their easing cycles,” Citi analysts said.
Emerging market debt denominated in local currencies has been a weak segment of global bond markets so far this year.
JPMorgan’s benchmark debt index has risen just under 4% this year, lagging its dollar version, which has risen more than 8%.
Many local currency bonds have risen since the Fed announced a rate change last month – with Chairman Jay Powell saying in his Jackson Hole speech that “the time has come” for rate cuts.
However, Pradeep Kumar, emerging markets portfolio manager at PGIM, acknowledged that investors had been deterred by a series of unforeseen factors.
“Emerging markets have been quite attractive this year from a valuation perspective, but sentiment has not been very good,” he said.
Some emerging markets were hit last month by global market volatility that slowed a business that has been going on for years Investors borrowed in yen at low rates and bought high-yielding securities such as Mexican peso bonds and Brazilian real bonds. Those bonds were sold off sharply last month as the Japanese currency strengthened and emerging-market currencies depreciated.
Demand for Mexican bonds also fell after the country’s ruling party won support from radical constitutional changes in which judges will be elected, a move that investors fear could undermine the rule of law.
Brazilian debt has also been sold off this year as markets fret over the fiscal commitments of Luiz Inácio Lula da Silva’s government. Faced with rising inflation and growth expectations, Brazil’s central bank, the BCB, did the opposite and raised interest rates for the first time in two years. The quarter-point hike took its benchmark rate to 10.75%.
“The combination of the Fed rate cut and a BCB rate hike, both indicating that they will likely continue to move in their respective directions over the coming months, is clearly supportive of the Brazilian currency, the real,” said Graham Stock, emerging markets strategist at RBC BlueBay Asset Management.
South Africa has long faced potential political instability, but Robert Simpson, senior portfolio manager at Pictet Asset Management, said a change in the composition of the government removed some of the risk associated with South African debt. He added that total yields were expected to rise in line with a rate-cutting cycle.
Those issues, combined with the U.S. presidential election, continue to make some investors cautious. A Trump victory in November could trigger a series of tariff measures that could reduce U.S. 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 aftermath of the global financial crisis, when if the Fed cut rates, investors could buy with their eyes closed. We need to be more selective,” Kumar said.
