Investors are hoping that US interest rate cuts will provide a boost to emerging market debt

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The jumbo interest rate cut by the US Federal Reserve is likely to ease pressure on indebted emerging markets and boost demand for local currency bonds after a period of dismal returns, investors say.

Central banks, including those of South Africa, Turkey and Indonesia, cut their own monetary policy rates or made accommodative hints this week as the first US interest rate cut in four years may end a dollar dominance that it shook their savings. .

Investors now hope that lower US rates, plus a potential “soft landing” in which the US economy avoids a recession that would have dragged down developing countries, will help draw money back into emerging market debt.

“It looks like we’re at a sweet spot where we’re not too worried about U.S. inflation anymore, (but it’s also not) that the U.S. economy has to be floating off the rocks,” said Paul McNamara, a portfolio manager at emerging market debt. at GAM. “It’s positive for emerging markets.”

Lower U.S. rates typically hurt the dollar and push investors toward riskier, higher-yielding assets, boosting emerging market currencies and making it easier for developing countries to repay foreign-denominated debt.

Markets are currently pricing in more than seven quarters of a point rate cut by the Fed next year.

Emerging market specialists hope this new era will help local currency bonds, in particular, outperform in the coming months as central banks have more room to cut their own key rates.

“Emerging market central banks have more room to respond to their local inflation profile and ease more than they would otherwise,” said Christian Keller, head of economic research at Barclays.

Many emerging markets raised rates faster than developed economies when global inflation rose, leaving them in a better position as the Fed now moves to ease.

Against this backdrop, South Africa’s Reserve Bank cut interest rates for the first time in four years on Thursday by 0.25 percentage points to 8% from the highest levels in nearly two decades in real terms. And Indonesia also announced a surprise discount this week.

Even Turkey’s central bank, which has battled double-digit inflation with interest rates of 50 percent this year, on Thursday dropped a key reference to the need for further tightening in its latest monetary policy statement.

“We now expect most central banks in emerging markets to cut much less than in the US, either because they have never needed to hike as much to re-anchor inflation to target. . . or are in the more advanced stages of the easing cycle,” Citi analysts said.

Emerging market debt denominated in local currencies has been a weak corner of global bond markets so far this year.

A benchmark JPMorgan debt index has risen just under 4 percent this year, lagging its dollar version, which has risen more than 8 percent.

Many local currency bonds have rallied since the Fed signaled a rate hike last month — with Chairman Jay Powell saying in his Jackson Hole speech that “the time has come” for rate cuts.

However, Pradeep Kumar, an emerging markets portfolio manager at PGIM, admitted that investors were deterred by a number of unforeseen factors.

“Emerging markets have been pretty attractive this year from a valuation perspective, but the sentiment hasn’t been great,” he said.

Some emerging markets were hit last month by global market volatility, which halted a years-long drive to borrow in yen at low rates and buy high-yield debt such as Mexican peso and real-denominated bonds Brazilian. They took a sharp turn last month as the Japanese currency rallied and emerging market currencies depreciated.

Demand for Mexican bonds also fell after the country’s ruling party pledged its support for sweeping constitutional changes to elect judges, a move investors fear will undermine the rule of law.

Brazilian debt has also sold off this year as markets worry about the fiscal commitments of Luiz Inácio Lula da Silva’s government. Amid rising inflation and growth forecasts, Brazil’s central bank – BCB – went in the opposite direction and raised interest rates for the first time in two years. The quarter point increase took the benchmark to 10.75%.

“The combination of a Fed rate cut and a BCB hike, both signaling that they are likely to continue moving in their respective directions in the coming months, is the most obvious support for Brazil’s currency, the real,” Graham Stock said. , emerging markets strategist at RBC BlueBay Asset Management.

South Africa has long been overshadowed by potential political instability, but Robert Simpson, senior investment manager at Pictet Asset Management, said a change in government structure is removing some of the risks associated with South African debt. He added that there is an expectation that total yields will rise in line with a rate-cutting cycle.

That catalog of problems, combined with the US presidential election, still keep some investors wary. A Donald Trump victory in November could lead to a round of trade tariffs that could reduce US demand for imports, strengthen the dollar and weaken emerging market economies and currencies that rely on cross-border trade.

“There was a period following the global financial crisis where if the Fed had cut, investors could buy with their eyes closed. You have to be more selective,” Kumar said.