Despite some risks and the need for careful security selection, both the internal and external backdrop appear quite promising for the asset class.

Ample room for EM rate cuts

On the internal side, inflation has largely been moving lower in most EMs, and in several cases is already at or very near central bank target levels. This means that despite headline yield compression, EM real yields are actually still attractive since interest rates remain elevated and have only just started coming down.

Of course, there is an expectation that policy rates will reduce further – this is reflected in current pricing. However, as shown below, what’s currently priced for EM policy rates in two years’ time, is above the 10-year average policy rate in most cases.

This suggests that the market does not envisage any scenario where EM interest rates might have to fall to more stimulative levels. In our view this is probably too sanguine, since in some cases growth could well disappoint, which then may necessitate more rate cuts than are currently being priced in. Such an outcome would, of course, be positive for local bond market returns.

The importance of the Fed’s new rate-cutting cycle

On the external side too, with the US Federal Reserve (Fed) recently initiating a new rate-cutting cycle, the backdrop for EM local currency bonds is now unambiguously more favourable. This is because lower US interest rates tend to put downward pressure on the US dollar, which helps EM currencies. Indeed, this dynamic has been well in evidence of late, with the foreign exchange (FX) return of the JPM local currency index  exceeding 2% in September alone [1].

Why do lower US rates tend to weaken the dollar? There are many ways to explain this tendency. All broadly centre on reduced holding period returns from holding US dollar assets. For example, high rates in the US encourage American investors to keep money in the bank rather than taking on riskier investments overseas. Sometimes they may even reduce riskier investments overseas and bring money home, putting upward pressure on the dollar. And now with US rates declining, this dynamic is working the other way.

This can also be viewed in terms of the ‘carry trade’, where borrowing in a low-rate country finances buying the currency of a high-rate country. A similar logic is seen in US dollar deposits in many EMs being at all-time highs. This reflects the fact that when US rates are elevated, the benefit of holding or ‘carrying’ dollars is higher than for the local currency. 

Beyond favourable EM currency effects, it is worth noting that US rate cuts could also potentially have some positive impact on EM local bond returns, by making some EM central banks more inclined to do the same.

Hedging against weaker global growth

Arguably, US interest rate cuts are now well priced in. However, in the event of US growth disappointing, it’s possible that rates might have to be cut to more stimulative levels, which, again, could be EM currency-positive. In the case of Europe, recent manufacturing data suggest that disappointing growth is a more live risk, which could potentially benefit Euro investors’ currency returns from EM local currency bonds.

In China meanwhile, weaker-than-desired growth is already more of a reality than a risk. Indeed, this explains why in late September, the authorities signalled a major ramping up of fiscal and monetary support for the economy. The rate cut from the Fed was probably one of the triggers for this. From the EM  perspective, in our view, a plausible positive result of this could be increased support for the currencies of those EMs that export a lot to China.

Key risks

While the overall internal and external backdrop is shaping up quite positively for EM local currency  bonds, as ever, there are some issues to be mindful of. Often in EMs the most notable risks are internal and country-specific, which underscores the need for careful country selection.

On the external side, there is naturally more heightened concern at present regarding the worsening and expanding conflict situation in the Middle East. This could have an adverse impact through more generalised increased risk aversion and/or higher oil prices that potentially begin to push EM inflation higher once again.

The upcoming US presidential election is another key risk factor for EMs. While the result seems50:50, a Trump victory is widely seen as likely to entail higher tariffs on all imports arriving in the US, with especially aggressive tariff hikes likely for Chinese-made goods. This would be negative for EM local currencies, as reduced US imports would likely support both US external accounts and the US dollar.

Putting everything together

Putting everything together, risks and the need for careful country selectivity notwithstanding, we feel that on the whole both internal and external conditions now appear quite favourable for EM local currency bonds. Internally, declining inflation is supporting EM real yields, enabling local rate cuts, which also potentially might go beyond what is currently priced in. Externally too, the new US-rate cutting cycle is a major positive that is weakening the US dollar and boosting the performance of EM currencies.