EM Sovereign Debt: Real Rates Come into Play

Taming inflation has been a priority in developed markets this year, but most emerging markets (EM) central banks were ahead of the curve and began hiking rates in 2021. Most emerging markets in the J.P. Morgan GBI–EM Global Diversified Index now have significantly higher nominal rates compared to developed markets. Further, there are signs of inflation peaking in many EM countries, where real interest rates are already in positive territory. Developed markets appear to have been behind the curve, and despite recent hikes, real rates remain negative virtually across the board.

Real Policy Rates

(adjusted by expected inflation)

Source: VanEck Research, Bloomberg LP; as of September 2022.

This divergence points to potential opportunities for EM bond investors. Positive real rates mean that local bond investors are being compensated for investing in bonds even after accounting for the effect of inflation on returns. The more challenging question for investors is whether or not the U.S. dollar will continue to outperform. To be sure, the U.S. dollar’s strength has been relentless since mid–2021, and it’s extremely difficult to predict when that may ease. However, we believe the significant real yield differential should provide support to EM local currencies. A possible expansion of the growth gap between Emerging Markets (EM) and the U.S. in 2023 could also be supportive of EM currencies.

Further, with emerging and developed markets at different stages of their hiking cycles, we believe the rate’s outlook favors emerging markets. With persistent inflation that has been consistently run higher than expectations and central banks that were extremely slow to react, no sign that developed markets policymakers are done hiking as they work to both bring inflation down to target levels and regain credibility. Many emerging markets began hiking earlier and with inflation expected to peak later this year in many countries, policy rates in EM are expected, on average, to begin declining by mid–2023. Brazil’s central bank, for example, began raising rates in the first quarter of 2021, and since then benchmark rates have risen from 2% to 13.75%. At its most recent meeting on September 21, the same day the FOMC announced another 75 bps hike and signaled more to come, Brazil held rates steady. The Brazilian Real is one of the few currencies having outperformed the U.S. dollar year–to–date 2022. There are some notable exceptions such as Turkey, which has one of the highest inflation rates globally, resulting from an unorthodox easing cycle pursued by the government since last year. In addition, there are regional differences. While the biggest rate cuts are expected in Latin America, many Asian and EMEA central banks are expected to keep rates steady next year to keep inflation under control. Overall the nominal yield gap between EM and the U.S. remains significant, as the J.P. Morgan GBI–EM Global Core Index has a weighted average yield of nearly 8%. Only China and Thailand have yields along the curve that are lower than those in the U.S.

There is a clear divergence between emerging and developed economies in terms of both current real and nominal rates, as well as the policy direction expected over the next year. Most EM countries are ahead of the U.S. in terms of the rate hike cycle. They are very likely to reach terminal rates sooner, and some may have already. This also means the EM central banks may have more flexibility built into their monetary policies and may be more able to react to growth slowdowns with policy actions. While the behavior of EM currencies versus the U.S. dollar will help determine just how much flexibility their central banks have, local bond investors stand to benefit from both high carry and potential rate cuts before they start occurring in developed markets. Although local currency bond investors have had to grapple with both weak currency returns and higher rates to confront inflationary pressures over the past 18 months, we believe conditions going forward may favor EM local currency bonds over developed markets alternatives for the foreseeable future.

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