The next big bet in emerging markets hinges on when rate cycles peak

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(Bloomberg) — Emerging-market debt traders have a new challenge: predicting which central banks will be the first to halt rate hikes, then buy bonds from those countries.

While it may seem premature to investors digesting the Federal Reserve’s first interest rate hike since 2018, Latin America emerged as the favorite in this high-stakes guessing game after countries in the region began to tighten aggressively about a year ago. Brazil signaled that a hike scheduled for May would likely be the last after raising rates by nearly 10 percentage points in just 13 months, and the central banks of Chile and Colombia raised borrowing costs the month last less than predicted by economists.

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Of course, higher-than-expected inflation could still derail this change, but the promise of a “maximum rise” for some countries in the region has BNP Paribas Asset Management and PineBridge Investments LP predicting that the curves will steepen in Latin America, creating shorter-term opportunities. maturity debt. Goldman Sachs Group Inc. recommends steepening — a strategy in which investors bet on shorter-term bonds versus longer-term bonds — particularly in Brazil and Chile.

“We expect some central banks in Latin America to start slowing the pace of their up cycle as we believe they are approaching their terminal rates,” said Clément Niel, fund manager at BNP Paribas Asset. Management in London. “Curves should start to steepen as inflation slows and central banks start considering rate cuts.”

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Striking contrast

The contrast with emerging Asian markets is stark. Central banks in India, Malaysia, Indonesia, Thailand and the Philippines are only expected to start raising rates in the second half of this year, according to the median estimate of economists polled by Bloomberg. The policy tightening should weigh on shorter-dated bonds and flatten the yield curve.

In Europe, while policymakers in Poland, Hungary and the Czech Republic have already raised rates above pre-pandemic levels, they are expected to remain hawkish as their proximity to the war in Ukraine adds further uncertainty to their economic prospects and causing the prices of their energy imports to soar. Both of these factors are negative for their bonds.

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Read more: Soaring oil prices give resource-rich emerging markets a boost

This has emphasized Latin America, where yield curves have room to steepen as they are now below their long-term averages. The shorter end of the Brazilian yield curve is currently inverted, with two-year yields more than 70 basis points higher than five-year ones, compared to an average spread of 147 basis points positive since April 2017. The two-to-five spread in Mexico is about 10 basis points, below the long-term average of 24 basis points.

“Signals of slower tightening, or even a pause, by Latin American central banks engaged in more mature up cycles, primarily Brazil and Chile, could give way to more pronounced steepening than the current prices, consistent with historical patterns after emerging market yield curve inversions,” wrote Goldman Sachs strategists Davide Crosilla and Kamakshya Trivedi in London in a research note last month.

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For others like Cathy Hepworth, head of emerging markets debt at PGIM Fixed Income in Newark, it’s really hard to say that Latin America is at the end of its bull cycle, as headline inflation and the Core inflation is drifting to multi-year highs. .

“What you need to do is keep focusing on the flatteners because it’s too difficult. The margin of error is way too high to call for a spike in inflation,” she said. “So being on the front of the curve is risky, and if you’re convinced that at least some positions farther down the curve are selling in excessive upsides, that would argue in favor of the flattening position.”

Exchange Bonuses

Strengthening regional currencies also give Latin American policymakers the opportunity to limit increases by helping to suppress imported inflation. Five of the six best-performing emerging market currencies this year are from Latin America, thanks in part to the rally in commodities that has benefited these resource-rich countries.

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“The surprise strength of Latin American currencies in the face of geopolitical risk and a hawkish Federal Reserve could allow central banks to tighten less than warranted by short-term inflation fears,” said Anders Faergemann, senior portfolio manager. at PineBridge Investments in London. “The unexpected appreciation in exchange rates should cause central banks in Latin America to ease off sooner than the market currently expects.”

Here are the main things to watch in emerging markets over the coming week:

Investors will watch updates on Russia following its unexpected and massive rate, market moves in Sri Lanka and Lebanon’s progress with the IMFSouth Korea’s central bank is expected to keep its key rate at 1.25% on Thursday , after raising its benchmark by 75 basis points from August last yearIndian retail inflation data due on Tuesday is expected to show further gains in March, topping the upper end of 6% out of central bank’s target range for a third monthChina’s March inflation data forecast for Monday is expected to rise to 1.4%, which may continue to give the central bank room to maintain a dovish bias . Turkey will announce its key one-week repurchase rate on Thursday. The central bank kept the benchmark unchanged at 14% this year despite inflation accelerating to its highest level in two decades in March.

©2022 Bloomberg LP

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