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How Much Room for Rate Cuts?

January 18, 2023

Read Time 2 MIN

Established disinflation and high real rates are the main reasons why EM bonds look interesting, and the market continues to price in fairly aggressive rate cuts in EM.

Rate Cut Expectations

The market expectations for policy rates are often jittery, but the predominant narrative remains intact – rate cuts are coming because inflation is easing and global growth is slowing. Well, today’s combo of lower producer prices and weaker retail sales in the U.S. matched this storyline. However, a possibility of a stronger post-pandemic rebound in China is a force to recon with (both as regards global GDP and inflation). In contrast, the weaker U.S. Dollar could be outright inflationary (via import prices). As of this morning, the market priced in two more small hikes by the U.S. Federal Reserve (Fed). followed by a relatively long pause and a rate cut sometime in the fall. The market expectations for emerging market (EM) rate cuts are often more aggressive – and for a good reason. Disinflation is more established, most EM central banks started to hike earlier than the Fed, and the real policy rates in EM are significantly higher than in all DMs (on a forward-looking basis – see chart below). The last point is one of the reasons why we are optimistic on EM bonds in 2023.

Global Disinflation

Today’s downside surprise in South Africa (both core and headline) is a good example of EM disinflation gone in right direction. South Africa’s headline inflation eased to 7.2% year-on-year, which brings it closer to the official target, and details of the release suggest that inflation can get back to the target range faster than expected. This, in turn, signals that the central bank might opt for a smaller 25bps rate hike next week and that this hike might be the last in the current cycle. This is not a bad setup for a major constituent of J.P. Morgan’s EM local bond index (South Africa’s weight in GBI-EM is about ~10%) - albeit whether or not the South African central bank would have room for a rate cut (currently priced in for H2-2023) will depend on fiscal performance, as well as political/policy noise (including calls for the central bank’s nationalization).

China Rebound And EM

We expect some residual policy tightening in other parts of EM as well – in EM Asia in particular (the region was a latecomer for the global tightening cycle). Both Indonesia and Malaysia have their rate-setting meetings tomorrow, and both are expected to deliver small (“farewell”?) 25bps rate hikes. With disinflation already underway (and from lower levels than in most EMEA or LATAM) and growth expected to piggyback on China’s reopening, Indonesia is considered an attractive destination for EM bond investors this year. Stay tuned!

Chart at a Glance: EM Real Policy Rates – Time for a Trim?

Chart at a Glance: EM Real Policy Rates - Time for a Trim?

Source: VanEck Research; Bloomberg LP.

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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