In hard currency emerging market debt, there was a big positive contribution from US Treasury yields, with the 10-year yield falling 45 basis points (bps) to 3.47% over the month. The key driver was stress in the banking system. In the US, the failure of Silicon Valley Bank and Signature Bank was swiftly followed by the rescue of European bank Credit Suisse, through a merger with UBS, which was coordinated by the Swiss government. The effect of the banking upheaval was a ‘flight to safety’ and moderating expectations regarding future US monetary tightening, both of which increased demand for US Treasuries. Owing to the risk-off sentiment, hard currency emerging market debt spreads widened by a sizeable 37bps; but the negative impact of this was more than offset by Treasury strength, resulting in the positive total return for March.

In local currency debt, there was a sizeable positive impact from FX, as emerging market currencies were helped by US dollar weakness. This was largely the result of the banking turmoil and revised US policy rate expectations. Additionally, there was a sizeable positive contribution from local currency bond returns. In emerging market corporate debt, spreads widened significantly. However, this was outweighed by the contribution from lower Treasury yields, resulting in the positive total return over the month.

Outlook

Despite all the challenges, emerging market debt assets remained remarkably resilient In March. Heightened rates volatility due to banking worries and potentially broader concerns in developed country credit markets could harm emerging market valuations; however, lowered expectations for the US Federal Funds terminal rate and less ‘US growth exceptionalism’ could benefit emerging markets. Softness in US inflation data would also provide a further boost to emerging market currencies, as US dollar strength founded on rate differentials would reverse.

China's accelerating recovery remains an upside risk, albeit with weaker positive spillover effects so far than expected. A near ‘Goldilocks’ scenario for emerging market debt would be a combination of moderating Fed rate expectations, with weaker US growth and a softer US dollar. On the other hand, the two scenarios that could lead to a more risk-off environment would be upwardly revised US interest rate expectations due to stickier US inflation and/or markedly increasing financial stability risks.