Investors are ploughing money into emerging market local currency bonds, as high interest rates and falling inflation make them increasingly attractive compared with dollar assets.
In the first four months of the year, investors withdrew a net $2.65bn from funds holding so-called hard currency — predominantly dollar-denominated — emerging market bonds, but added $5.23bn to local currency bond funds, according to fund flow data provider EPFR Global.
The flows mark a reversal of years of investors opting for dollar-denominated debt as a strong greenback broadly drove better and lower-risk returns. This year, the tables have turned with local bonds performing better, as currencies including the Mexican peso and Brazilian real have strengthened more than 10 per cent against the dollar.
“Local markets are far outperforming external debt,” said Paul Greer, emerging markets debt portfolio manager at Fidelity International. “Frankly I think that trend will probably continue for the rest of the year.”
This year JPMorgan’s emerging market benchmark for local currency government bonds has delivered a 6.8 per cent total return, outstripping a 1.9 per cent rise for its hard currency counterpart.
Analysts say much of that outperformance has been down to the fact that this year the dollar has weakened against many major developing country currencies that also offer higher rates of return. Such an uplift in return is known as “carry” in foreign exchange markets.
“The carry trade is front and centre of people’s minds,” said Manik Narain, head emerging market strategist at UBS. “There is a strong consensus to be short the dollar, on the basis of the Fed having reached the end of its tightening cycle.”
Jay Powell, the Federal Reserve chair, has indicated that the central bank was preparing to hold off on another rate rise next month. However, it has been more cautious as to when rate cuts will commence.
Kamakshya Trivedi, head of global foreign exchange, rates and emerging markets strategy at Goldman Sachs, said investors were still keen on the trade.
“The view being that with the Fed on pause, that should lower interest rate volatility and create some room for investors to earn the risk premium on offer in specific higher-yielding emerging market foreign exchange,” he said.
While some analysts think emerging market currencies will struggle to continue to outperform the dollar, especially against a backdrop of concerns about the US debt ceiling or a US recession, many still see reasons to hold local currency bonds.
“We have seen a clear divergence between emerging market local and hard currency bonds over the past few quarters with local currency debt looking more attractive on a fundamental and valuation basis,” said Thanos Papasavvas, chief investment officer at ABP Invest.
Many emerging market central banks started raising their interest rates before the Fed did and were able to tame inflation quicker. For countries where interest rates remain high, that has improved the real yields on offer to investors.
In Brazil, for example, the policy interest rate has been 13.75 per cent since last August while April’s inflation print showed annual price rises of 4.15 per cent. In Mexico, the policy rate rose to 11.25 per cent in April while annual inflation eased to 5.3 per cent.
Added to attractive emerging market real yields, the Fed is widely thought to have finished its rate rising cycle with markets pricing in cuts of about 0.7 percentage points before the end of the year.
“Earlier hiking cycles, falling inflation and signs that the US tightening cycle has peaked have given an opportunity in emerging market debt local rates,” said Steve Ryder, a senior portfolio manager at Aviva Investors.
“We like being overweight Mexican bonds both outright and versus the US as we believe the central bank is also close to its peak in interest rates, and with inflation expectations continuing to fall we believe the case for rate cuts is growing” Ryder said. Falling interest rates make bond prices rise and yields fall.
Goldman picked Brazil, Hungary and Mexico as its chosen “carry candidates” and warned against the South African rand, which hit a record low against the dollar last week after the US accused South Africa of supplying arms to Russia in a covert naval operation.
Nevertheless, many investors remain cautious on the outlook for emerging market assets, with positioning still low compared with historical levels.
“Confidence is very low,” said David Hauner, head of EM cross-asset strategy at Bank of America Global Research. “People are very long cash and waiting for trends to emerge.”
Like Narain at UBS, he said some investors had taken an overly rosy view of the outlook for US rate cuts, which BofA did not expect to begin before next year.
Even so, he said, the question was now when rather than whether the Fed would begin cutting.
“Inflows to EM local currency debt will start to accelerate when there is more confidence in the beginning of the Fed’s cutting cycle,” he said. “Everybody is waiting for that green light.”
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