Investors hope US rate cuts will provide lift for emerging market debt

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The US Federal Reserve’s significant interest rate cut is expected to alleviate the burden on indebted emerging markets and stimulate demand for local currency bonds following a period of lackluster returns, according to investors.

Central banks in countries like South Africa, Turkey, and Indonesia have either reduced their own policy rates or hinted at a more accommodative stance this week, as the first US rate cut in four years signals a potential shift away from the dollar dominance that has negatively impacted their economies.

Investors are optimistic that the combination of lower US rates and the possibility of a “soft landing” for the American economy, avoiding a recession that could have adversely affected developing nations, will attract capital back into emerging market debt.

“We seem to be in a favorable position where concerns about US inflation have eased, and there isn’t a pressing need for drastic measures to stabilize the US economy,” said Paul McNamara, an emerging market debt portfolio manager at GAM. “This bodes well for emerging markets.”

Lower US rates typically lead to a weaker dollar, prompting investors to seek higher yields in riskier assets, thereby boosting emerging market currencies and facilitating debt repayment for developing countries with dollar-denominated debt.

Markets are currently pricing in more than seven quarter-point rate cuts by the Fed in the next year.

Specialists in emerging markets are hopeful that this new environment will benefit local-currency bonds, particularly in the months ahead, as central banks gain more flexibility to lower their own interest rates.

“Emerging market central banks now have the leeway to respond to local inflation dynamics and ease monetary policy further than they would have been able to previously,” said Christian Keller, head of economics research at Barclays.

Many emerging markets acted swiftly to raise rates during periods of global inflation, positioning them well as the Fed transitions to a more accommodative stance.

Against this backdrop, the South African Reserve Bank cut interest rates for the first time in four years on Thursday, while Indonesia also announced a surprise rate cut this week.

“We anticipate that most emerging market central banks will be more conservative in their rate cuts compared to the US, either because they didn’t need to raise rates as much previously to combat inflation or because they are further along in their easing cycle,” noted Citi analysts.

Local-currency emerging market debt has been underperforming in global bond markets this year.

A JPMorgan index tracking this debt has seen a modest increase of under 4% this year, lagging behind a dollar-denominated version which has risen over 8%.

Several local currency bonds have seen a rally since the Fed signaled a shift in rates last month, with Fed Chair Jay Powell indicating in his Jackson Hole speech that rate cuts were imminent.

However, Pradeep Kumar, an emerging market portfolio manager at PGIM, acknowledged that unforeseen factors have dampened investor sentiment.

“Emerging markets have been attractive from a valuation standpoint this year, but sentiment has been tepid,” he said.

Some emerging markets faced volatility last month that disrupted a trend of borrowing in yen at low rates to invest in high-yielding debt such as Mexican peso bonds and Brazilian real-denominated bonds. This trend reversed as the Japanese currency strengthened and emerging market currencies depreciated.

Demand for Mexican bonds also waned after the ruling party pushed through constitutional changes allowing for the election of judges, raising concerns about the rule of law.

Brazilian debt also faced sell-offs amid worries about the fiscal policies of the government led by Luiz Inácio Lula da Silva. Despite rising inflation and growth projections, Brazil’s central bank raised interest rates for the first time in two years, bringing the benchmark rate to 10.75%.

“The combination of the Fed’s rate cut and the BCB’s rate hike, both signaling future moves in their respective directions, is particularly supportive for the Brazilian real,” said Graham Stock, emerging market strategist at RBC BlueBay Asset Management.

South Africa, long plagued by political uncertainty, is seeing some of those risks dissipate with changes in government, according to Robert Simpson, senior investment manager at Pictet Asset Management. He anticipates higher total returns in line with the ongoing rate-cutting cycle.

Despite these positive developments, the upcoming US presidential election and the potential implications of a victory for Donald Trump are keeping some investors cautious. A Trump win could lead to trade tariffs that reduce US imports, strengthen the dollar, and weaken emerging market economies and currencies reliant on international trade.

“In the aftermath of the global financial crisis, a Fed rate cut used to be a signal for investors to buy indiscriminately. Now, a more discerning approach is necessary,” Kumar remarked.