Chief Economist, Emerging Markets Fixed Income
U.S. Fed Rate Hikes
The U.S. Federal Reserve Chairman’s testimony scared the market into pricing even more rate hikes. The peak rate implied by the Fed Funds Futures reached 5.65%, the implied probability of June’s hike is now above 80%, and the market thinks that the Fed might opt for a larger 50bps hike this month. Today’s above-consensus ADP employment print (242k) did little to dissuade the market hawks. So, we are waiting for the Fed’s Beige Book this afternoon with some trepidation. What does it all mean for emerging markets (EM) bonds? The chart below shows that the rising “risk-free” rate was the main factor that affected sovereign returns in February and March – across all rating categories. In addition, the rising volatility of “risk-free” rates pushed down spread returns on lower-rated EMs – in part due to concerns about their structural and institutional ability to handle higher global rates.
What we find quite interesting though is that the market continues to price in – still cautiously – policy rate cuts in various EMs, despite the rising expectations for the U.S. peak rate. Why? Because many EMs tightened early and aggressively in response to rising price pressures (=high real rates), and inflation is clearly moderating (albeit sometimes in a “bumpy” manner). This week’s big inflation data dump in EM looks promising so far – we had good results in EM Asia yesterday (Philippines and Thailand), which were followed by another downside surprise in LATAM (Chile). If everything goes according to plan, inflation prints in Mexico (Thursday) and Brazil (Friday) should reaffirm the EM disinflation trend.
EM Fiscal Outlook
One potential headwind for EM doves is fiscal slippage. Brazil is a great example to illustrate this point. Brazil’s real policy rate based on expected inflation is super-high (around 8%), but the uncertainty about new administration’s spending plans kept the market and the central bank on defensive for quite some time. The recent reduction in political noise and a promise of decent tax reform did wonders for the rate cut expectations though – and there is definitely more to come if the administration stays fiscally responsible. Another example is Hungary, where a surprising fiscal splurge (around 50% of the annual deficit target in the first two months of the year) raised questions about the easing timeline, even though headline inflation finally peaked and food/core services pressures are moderating. Stay tuned!
Chart at a Glance: U.S. Fed Hawks and EM Sovereign Bonds
Source: Bloomberg LP. Data from 1/31/2023 to 3/7/2023.
PMI – Purchasing Managers’ Index: economic indicators derived from monthly surveys of private sector companies. A reading above 50 indicates expansion, and a reading below 50 indicates contraction; ISM – Institute for Supply Management PMI: ISM releases an index based on more than 400 purchasing and supply managers surveys; both in the manufacturing and non-manufacturing industries; CPI – Consumer Price Index: an index of the variation in prices paid by typical consumers for retail goods and other items; PPI – Producer Price Index: a family of indexes that measures the average change in selling prices received by domestic producers of goods and services over time; PCE inflation – Personal Consumption Expenditures Price Index: one measure of U.S. inflation, tracking the change in prices of goods and services purchased by consumers throughout the economy; MSCI – Morgan Stanley Capital International: an American provider of equity, fixed income, hedge fund stock market indexes, and equity portfolio analysis tools; VIX – CBOE Volatility Index: an index created by the Chicago Board Options Exchange (CBOE), which shows the market’s expectation of 30-day volatility. It is constructed using the implied volatilities on S&P 500 index options.; GBI-EM – JP Morgan’s Government Bond Index – Emerging Markets: comprehensive emerging market debt benchmarks that track local currency bonds issued by Emerging market governments; EMBI – JP Morgan’s Emerging Market Bond Index: JP Morgan’s index of dollar-denominated sovereign bonds issued by a selection of emerging market countries; EMBIG – JP Morgan’s Emerging Market Bond Index Global: tracks total returns for traded external debt instruments in emerging markets.
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