Bets on rate hikes in emerging markets like South Africa are getting too high

When it comes to betting on higher borrowing costs in developing countries, some investors may be getting ahead of themselves.

In markets from South Africa to Mexico and South Korea, traders envision a faster pace of interest rate hikes than economists currently say is justified based on the inflation outlook.

“Almost all are overvaluing the tightening,” said Shamaila Khan, head of emerging market debt at AllianceBernstein in New York, whose $ 4.7 billion high yield bond fund has exceeded 86% of its peers last year.

The positioning reflects a common motive in the markets: After months of Covid-19 foreclosure, there is a risk that policymakers will put their economy on hot water, only to turn back the clock with stronger-than-expected rate hikes.

But the debate carries additional weight in emerging markets, an asset class that is particularly sensitive to the Federal Reserve’s position. This suggests how trades could quickly play out on any sign of policy remaining loose, potentially rewarding investors keen to look beyond the bearish outlook.

In Mexico, for example, market prices for swaps suggest an upward cycle could begin as early as August, although the majority of economists say the central bank will refrain from tightening until at least February.

It’s a similar story in South Africa, where forward rate agreements provide for a 70% chance of a 50 basis point jump in six months, as Bloomberg’s monthly survey shows the rate will remain. unchanged until the end of the year.

Meanwhile, South Korea’s forward rate deals call for a rate hike of nearly 25 basis points over the next six months. In contrast, most economists do not foresee any change.

In this context, Khan of AllianceBernstein said that his fund favors the local debt of South Africa, Mexico and Russia, “where the markets have taken too much into account the trajectory of key rates”.

U.S. central bank officials may be able to start discussing when to cut back their bond buying program at upcoming policy meetings, Fed Vice Chairman Richard Clarida said last week.
Exceeding inflation

At the same time, the coronavirus continues to spread across large swathes of the developing world, adding to the need for more stimulus.

In India, traders canceled their bets on the rate hike last month as policymakers turned to a bond-buying program to prop up the economy against a new wave of infections. The Reserve Bank of India is expected to keep its benchmark interest rate unchanged on Friday and announce further debt purchases as the economy grapples with localized lockdowns implemented by most states.

JPMorgan Asset sees more gains for emerging bonds as dollar weakens

HSBC Holdings Plc says the prospect of central bank support being cut later than current market prices suggests there is value in the front-end of the yield curve, including in South Korea and in Poland.

This is a view shared by Edwin Gutierrez, head of emerging market sovereign debt at Aberdeen Asset Management in London.

“We are a long time in South Africa and Mexico because we think the price curve is in a rate hike path that is not likely,” he said.

Market correction

This is not to say that caution is not warranted. The Citi EM Inflation Surprise Index is at its highest since 2008, a reminder of how many investors have been caught off guard by the resurgence of inflation.

“The risks are probably tilted towards a faster rather than a slower tightening,” said Duncan Tan, strategist at DBS Bank Ltd in Singapore.

Inflation data from South Korea to Turkey and Poland this week may offer clues on the way to monetary policy. In Mexico, traders will watch the central bank’s quarterly inflation report on Wednesday for signs that the monetary authority may take a less accommodative outlook.

“Unless short-term data releases provide confirmation of what is priced, current market prices are vulnerable to a correction,” said Eugenia Victorino, Asia Strategy Manager at Skandinaviska Enskilda Banken AB in Singapore. .

“The market is already forecasting more hikes than fundamentals suggest,” she said.

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