The EM policy pivot is here

Overview
- EM policy rates appear to have peaked, and some EM central banks have begun to cut rates.
- We believe there is potential to lock in attractive income offered by high EM sovereign yields.
- However, we are selective and are monitoring the fiscal impact of divergent policy responses to the pandemic.
- Chile’s central bank surprised with a larger-than-expected policy rate cut in July.
The EM policy pivot is here
The emerging market (EM) policy pivot is here. The ferocious hiking cycle unleashed by rampant inflation caused by fiscal stimulus, supply chain challenges and currency pass through, has finally peaked. Early hikers have begun to cut and high policy rates and rapidly normalizing inflation have allowed central banks to cut more aggressively than expected. Chile cut its policy rate by 100 basis points in July to 10.25% (75 basis points expected), and Brazil cut by 50 basis points in August to 13.25% (37.5 basis points expected). The question now is will rate cuts impact these countries’ currencies?
In our view, this will depend on what happens to developed market (DM) policy rates. In our base case, EM real interest rate differentials are sufficiently high to withstand some pressure if DM central banks raise rates further in the coming months, assuming they do not hike more than is currently priced into markets. Based on this assumption, we currently see value in some higher yielding EM countries.
But we are selective, cognizant that some countries may face budgetary constraints caused by elevated policy rates and their different fiscal and monetary policy responses to the pandemic. Some countries’ financial metrics, such as debt-to-GDP ratios and debt service capacities, may suffer over the next few years and future growth could be curtailed. We are monitoring the potential for divergent economic outcomes among various EM regions and countries due to fiscal strains.
Nevertheless, with most of the rate hiking cycle behind us, we expect EM and DM sovereign bond market volatility to decline. This should allow investors to benefit from high nominal and real interest rates and to lock in elevated levels of investment income. In addition, the US dollar could soften as the Fed reaches its peak rate and seeks to ease policy rates over time. High interest rate differentials versus DMs have already benefited EM currencies this year and a weaker US dollar could allow EM currencies to be an additional source of return for investors. Given the current under-owned status of the EM asset class, we believe positive interest rate differentials and growth versus DMs could be a catalyst for capital flows into EM assets.
Market pulse
The Central Bank of Chile (BCCH) kicked off its long-awaited easing cycle in July with a larger-than-expected 100 basis point rate cut. After discussing a rate cut in June, the BCCH had surprised the market by remaining steady and waiting for more economic data. The June inflation report had surprised to the downside at -0.20% month-over-month, marking the third straight month of lower-than-expected inflation. The consolidation of the disinflation process combined with anchored long-term inflation expectations allowed the BCCH to surprise the market with its July cut. The post-meeting communication led to market expectations of additional cuts of similar magnitude through the remainder of the year. The board also revised lower its expectations for inflation and policy rates, leading us to expect the front end of Chile’s yield curve to outperform in this cycle. However, given Chile’s reduced carry and the potential for long positions to be unwound, we may see more attractive opportunities to gain exposure to the Chilean peso in the medium term.
Notes from the ground | Indonesia
The Bank of Indonesia (BI) kept its policy rate steady at 5.75% at its July meeting, in line with market expectations. The bank stated its decision was consistent with its target inflation range of 2%-4% this year and a new target range of 1.5%-3.5% for next year. The BI emphasized its focus on currency stability and the need to control “imported inflation” and mitigate “the impact of global financial market uncertainty”, which it considers to be high. We expect the bank to remain focused on the country’s currency as it anticipates another US Federal Reserve hike in September. The BI also eased its macroprudential stance, reducing lending costs to banks for priority sectors, effective October 1. We are skeptical of how effective these measures will be, however, considering the bank’s acknowledgement of weak corporate demand for credit. We expect private investors to remain on the sidelines ahead of Indonesia’s February elections.
Headline inflation eased by 40 basis points to 3.1% in July and core inflation fell by 20 basis points to 2.4%, broadly in line with expectations. Volatile food prices have remained well behaved, mostly due to better food supply management, although El Nino-related food inflation could pick up in September.
Second quarter GDP growth was slightly better than expected, at 5.2% year-over-year, accelerating from 5% in the first quarter due to stronger government investment and domestic consumption, despite lower net exports. In general, we think other regions, such as Latin America and Central and Eastern Europe, offer more attractive carry than Asian countries. We believe Indonesian interest rates are fairly valued and expect its yield curve to steepen through year-end, in line with the yield curve steepening currently taking place globally.