As the third year of central bank tightening continues, the difficulty in identifying the peak in policy rates has emerged as one of the cycle’s prominent hallmarks. Yet, several factors point to a deceleration in emerging market inflation, placing many emerging market (EM) central banks in the area of peak rates. As markets price in central bank holding patterns and eventual rate cuts, the question shifts to the breadth of the investment opportunities in local rates markets. The following places the current transition in the context of prior, post-GFC periods of elevated policy rates as a way of assessing the momentum behind the asset class and identifying the appropriate positioning across countries.
One only needs to look at the correlation between commodity prices and the yield on the benchmark local rates index to see emerging markets’ sensitivity to commodity prices (Figure 1). As such, inflation quickly beset the emerging markets during the COVID recovery and the early stages of the war in Ukraine due to the relatively high weighting of food and energy in their inflation baskets.
The Correlated Moves in Commodities and EM Local Rates
PGIM Fixed Income and Bloomberg.
Given the sudden onset of inflation, EM central banks led the global wave of policy tightening. In addition to the moderation in commodity prices, the benefit of their proactive approach is readily apparent as base-year effects take hold and tradable goods inflation slides while non-tradable services inflation slows at a more gradual pace. As a result, in most emerging market economies—with the exception of South Africa, Colombia, and Hungary—headline and core inflation have materially decelerated (Figure 2).
EM Inflation Simmers After the Boil
PGIM Fixed Income.
The evolving EM inflation backdrop raises the question of where central bank policy rates are headed, when they might do so, and the respective investment implications.
Rate Cut Prospects
Following the crescendo of EM central bank rate hikes at 21 in May 2022 (Figure 3), it is not surprising that markets priced in rate cuts over the coming months through the next two years.
EM Central Banks' Policy Decisions (Number of central banks hiking, cutting, or keeping rates on hold, per month)
PGIM Fixed Income and Macrobond.
For the EM central banks that started hiking as early as the second half of 2021 or early 2022, the timing and number of cuts that are priced in varies across countries (Figure 4). The market pricing for cuts generally depends on the starting point of the hiking cycle, the cumulative hikes thus far, as well as the dynamics around the long-term neutral policy rate. Furthermore, with 250 bps of rate cuts priced in for the U.S. Federal Reserve over the next two years, potential easing in U.S. policy could further deflate some of the strength in the U.S. dollar while alleviating downward pressure on EM currencies, thus providing another source of disinflation and policy-rate relief across emerging markets.
The Global Expectations for Cuts in Policy Rates
PGIM Fixed Income.
The Prior, Post-GFC Hiking Cycle
Viewing the market’s expectations for rate cuts from multi-decade highs in comparison to prior, post-GFC rate cycles provides context regarding the potential time between the last hike and first rate cut as well as the total amount of easing. From a broad, historical perspective, Figure 5 shows that once the policy rate is kept at sufficiently restrictive level for an extended period, the next move is generally the start of an aggressive easing cycle.
Indeed, the table indicates that it is very common for EM central banks to keep rates elevated for six to 12 months (or even longer) before starting an easing cycle. In addition, the higher the policy rate relative to country’s long-term neutral rate and the longer central bank’s pause, the bigger the easing cycle. In most cases, the scale of monetary easing was at least 50% of the cumulative hikes.
For example, Brazil’s central bank ended its prior hiking cycle in August 2016 at the peak Selic rate of 14.25% and stayed on hold for next 21 months before cutting the Selic rate by 775 bps. Chile’s central bank was on hold for 22 months at 5% and subsequently cut its rate to 3% between 2013 and 2014. In Central Europe, Czechia, Poland, and Hungary were on hold between six to nine months before embarking an aggressive cutting cycle.1 Thailand was on hold for only two months in 2011 before cutting base rate by 200 bps to 1.5%, but South Korea kept its base rate at 3.25% for almost 12 months after hiking by 125 bps in 2010-11, and it later slashed the rate by 75 bps.
EM Central Bank Tightening: Now and Then
PGIM Fixed Income.
When we extrapolate the historical precedent to current conditions, we find that the rate cuts priced into local yield curves have plenty of additional room to potentially adjust lower over a longer period of time, particularly as concerns about decelerating growth mount. This underscores the momentum behind the asset class as well as the rationale for long-duration positioning. The subsequent issue becomes identifying which curves may be appropriate for long-duration exposure.
Current Hiking Cycle
When shifting to the current cycle, those countries that were the earliest to tighten, the earliest to pause, or that implemented large scale rate hikes may be candidates for long-duration positioning. For example, Brazil and Czechia, both of which were early hikers in this cycle, have been on hold for more than nine months. Mexico started hiking in June 2021 and embarked on 725 bps of hikes through April 2023. Hence, the long duration positioning in these countries not only offers the potential for positive real yields as inflation pressures recede, but they also present the possibility for attractive total returns as yields drop in response to policy rate cuts.
Conversely, Colombia, South Africa, and Malaysia—relatively late and slow hikers as seen in Figure 4—recently surprised the market by hiking more than expected in April and May. As a result, optimal positioning in these countries may be more focused on underweight duration positioning at the front end of their curves. Underweight duration positioning may also apply in countries, such as Chile, where market pricing has exceeded our rate-cut expectations.
Finally, situations may warrant positioning in the intermediate portion of the curve. For instance, when compared to Latin America or Central and Eastern Europe, many Asian countries were less affected by the global surge in inflation amid China’s more moderate-than-expected reopening and lingering concerns about its real-estate sector. The disinflation spillover from China will likely influence monetary policies in the region, such as those for Indonesia and Thailand. In that context however, we still don’t expect South Korea to embark on a sizable policy easing since its central bank hiked to a post-GFC high, hence the risk-reward dynamic underscores positioning in the belly of the interest-rate swaps curve.
The post-COVID landscape for investing in EM local rates has been one of flexibility, and EM central banks’ leadership in tightening monetary policy initially warranted short-duration positioning at the front of yield curves. From an inflation perspective, the proactive approach to hiking rates appears to be benefitting the respective countries as inflation finally moderates across many countries. As we view the landscape for the potential scale of rate cuts, we see the opportunity for long positioning in several countries that appear to have ample room to loosen policy. Further allocation considerations include the critical role of carry and rolling down yield curves, which we’ll explore in future posts, in terms of identifying the opportunities and momentum behind the EM local rate markets.
1 Czech monetary policy has been somewhat unique. Between 2017 and 2019, the CNB hiked its repo rate from 5 bps to 2% and kept its rate on hold for eight months before hiking by 25 bps to 2.25%. The policy rate was later cut to 25 bps with few months due to COVID.