The start of the Federal Reserve’s easing cycle should support EM debt, as it creates an opportunity for local central banks to reduce rates and puts downward pressure on the USD. High yields on EM bonds also make them an appealing choice. While risks remain, particularly from the US election, the strong year-end seasonals could support performance once election uncertainties clear.
Federal reserve swings the pendulum
In recent quarters, we have preferred EM hard currency exposures. Hard currency debt, as a ‘spread product’ to US rates, has delivered reliable returns while Fed rates were high. Although yields remain elevated (the JP Morgan EMBI Global Diversified Index yield sits at 7.5%), the US rates market is now pricing in significant policy easing, and spreads to Treasuries are historically tight. This suggests limited potential for EM hard currency debt to achieve returns significantly above those of Treasuries.
Yields on local currency exposures, while somewhat lower at 6.05% (as indicated by the Bloomberg EM LC Liquid Index), have seen correlations with US Treasuries drop notably since early 2024. The 12-week rolling average of returns from Treasuries and EM local currency debt has dipped below 35%, which could add a diversification benefit for portfolios as US rate easing unfolds.
More reasons to favor local currency exposure
The Fed’s rate cuts tilt the balance toward local currency exposure for two main reasons:
1. Potential depreciation of the USD: The USD’s relative overvaluation has long limited returns on EM local currency assets. Despite the dollar’s most recent rise in early 2024, it has struggled since the Fed announced its plan to cut rates. Even the volatility of early August failed to ignite a flight to the dollar. As higher US rates lose their support, the USD could continue to weaken, potentially benefiting EM local currency assets.
2. Room for EM central banks to cut rates: Fed easing offers EM central banks more flexibility to reduce rates. While some have already begun easing, they have been cautious about extending cuts for fear of impacting their currencies due to widening rate differentials. With EM central banks’ real interest rates averaging 3.2%, compared to the Fed’s 2.5% and the ECB’s 1.45%, there remains ample space for EM central banks to adjust policy further.
These have combined to support returns over the past quarter, which for the Bloomberg EM Local Currency Liquid Govt Index were 4.2% in Q3 for currency returns and 2.8% for bond price returns. The final element to add in is the strong coupon flow of 1.2% for the quarter to bring total returns for Q3 to 8.3%.
Hurdles ahead
While interest rates in EM countries are high, central banks are not all on the same timeline. Brazil, for instance, raised interest rates on the same day that the Fed eased policy. Nonetheless, given high real yields and decreasing inflation pressures, the general trend should be for more rate cuts over the coming quarters.
Jason Simpson, Senior Fixed Income Strategist at State Street SPDR ETFs, points out that “the US election presents an additional challenge. If new tariffs were imposed under a Trump administration, economic growth in certain EM countries could suffer. This would likely be more impactful for equity investors but could still affect EM debt if it strengthens the USD or reduces investor risk appetite. China, in particular, could face pressures, although recent stimulus measures may help balance its economy by boosting domestic growth. In the 2016 election, EM debt initially dropped sharply but rallied in December 2016 as risk-on sentiment returned, spurred largely by a surge in equities.”
In 2024, election timing may align with seasonal market trends, as the final quarter has historically been favorable for EM debt. Over the past decade, returns in Q4 have been negative in only three years (2014, 2016, and 2021), with November and December showing particularly strong average returns of 2.1%.
