(Bloomberg) — Latin America’s local-currency bonds are staging the strongest monthly advance this year as the Federal Reserve draws closer to cutting interest rates for the first time since the onset of the pandemic.
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Bets that the long-awaited easing is poised to begin next month are helping to allay fears about a potential US recession that would ripple through the region, which has close trade ties to the world’s largest economy. The pivot is also expected to make it easier for central banks there to loosen monetary policy without triggering an exodus of cash to the US, driving traders to bid up bond prices in countries like Mexico, Chile and Peru in anticipation.
“The end of US exceptionalism, which would translate to a more dovish Fed and a weaker dollar, would be a tailwind for EM local bonds,” said Thierry Larose, a money manager at Vontobel Asset Management AG in Zurich.
Local-currency debt from developing nations was dragged down for most of this year as the surprisingly resilient US economy kept the Fed on hold, causing other currencies to weaken against the US dollar. Now that dynamic is reversing, removing what had been a drag on domestic bond markets in much of the developing world.
The shift is especially pertinent in Latin America, where central banks raised rates early to some of the highest in the world after the onset of the post-pandemic inflation wave. That resulted in large returns last year as investors seized on double-digit rates in the region.
Several countries already started cutting borrowing costs — which still remain well above those in developed countries — and speculation that lower US rates will allow for more easing has provided another boost.
“We believe the majority of emerging markets have room to cut interest rates further, to varying degrees,” said Alejo Czerwonko, chief investment officer for EM Americas at UBS Global Wealth Management. “The likely start of a Fed easing cycle this September will support them along the way.”
That helped to send an index tracking Latin America local currency bonds to a 1.9% gain so far in August, on track for the best advance since December. If confirmed, the advance would snap what had been a lagging run against emerging-market peers in Asia and Africa since June. Local government debt from Colombia, Peru, Brazil and Mexico were among the top performers this month.
The gains were enough to override the impact of the yen carry trade blow up, which had put pressure on local currencies as hedge funds sold off investments to repay Japanese loans that financed the positions.
Eric Fine, head of emerging markets active debt at VanEck, said the weakening of the Mexican peso — which is down 13% since the beginning of June, a sharp pullback after a steep run up that had pushed it to a nine-year high against the dollar — has made bond valuations more attractive. The Bank of Mexico has cut its overnight rate twice this year, to 10.75%, and is expected to keep nudging it downward.
The “yen trade washout gave us another opportunity in Mexico,” said Fine.
“We always thought it was fundamentally valuable,” he said, though he had previously worried that the run-up in the currency had thrown some technical risks out of whack. “Now we don’t.”
While Brazil is bucking the easing trend, with policymakers keeping rate hikes on the table due to a worsening inflation outlook, the hawkish approach has boosted longer-dated debt by strengthening investors’ confidence that the central bank will rein in consumer prices.
Edwin Gutierrez, head of emerging-market sovereign debt at Abrdn Plc. in London, said the local government bonds from Colombia and Peru are among his picks. Both ranked as top performers in emerging markets this month, each delivering about 3% returns compared to the average of less than 1%, according to data compiled on a Bloomberg index.
“We have been favoring rates trades in the region,” he said.
That trend may continue. Goldman Sachs Group Inc. strategists Tadas Gedminas and Kamakshya Trivedi said in a recent note to clients that it has been surprising how much EM fixed-income markets have rallied despite some of the volatility set off by the carry trade unwinding, but warned clients about betting on a reversal.
“We’re not inclined to fade the rallies,” they wrote.
–With assistance from Maria Elena Vizcaino, Davison Santana and Matthew Burgess.
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