Why are traders anticipating a ‘once in a lifetime’ bet on emerging markets?

One of last year’s best wagers in emerging-market debt is getting a fresh boost from bets the Federal Reserve will finally begin cutting interest rates.

Optimism is sweeping through domestic bond markets as investors wager that the Fed will soon start lowering rates, with Wall Street set to scour this week’s meeting for clues on timing. Alongside a weaker dollar, a potential US pivot would help coax central bankers in emerging markets to ease — resulting in a potential windfall for holders of local-currency debt.

To Grantham Mayo Van Otterloo & Co., that means a “once-in-a-generation” opportunity in local bonds. Latin American domestic debt is already fresh off its best annual rally since 2009 thanks to early and aggressive monetary policy in the region.

“Local debt is attractive with a rich dollar, cheap EM currency valuations, attractive yields and the ongoing disinflation process — no matter what the Fed does or says,” said Victoria Courmes, a money manager at GMO. “Hints at when the easing cycle is likely to start in the US could be a catalyst for a weaker dollar and strong performance from EM local debt.”

GMO is among a growing cohort of global money managers — from Neuberger Berman to Vontobel Asset Management and JPMorgan Chase & Co. — that tout early 2024 as an important moment for the asset class. 

Even though policymakers in nations such as Brazil and Chile are further along in their monetary cycles than peers in the US and Europe, a potential Fed pivot still stands to invite further easing. Traders currently price in a less-than-50% chance that US officials begin easing at the March gathering.

If the eventual pivot comes alongside a decline in the greenback, central bankers in emerging markets would be less likely to risk local-currency depreciation by also cutting rates. For traders, that scenario offers traders a unique opportunity.

As JPMorgan strategists including Anezka Christovova see it, inflation is coming down and growth should be resilient in the first half of the year. That leaves the case for local bonds intact as the Fed moves closer to lowering borrowing costs — even though emerging assets are sputtering at the start 2024, they wrote in a Jan. 19 note. 

Gauges of developing currencies and local government bonds are both down more than 1% so far this year due to uncertainty about the health of China’s economy and shifting bets on the timing of Fed rate cuts. But that, as GMO’s Courmes sees it, presents an attractive entry point for investors. 

Even the most sophisticated of Wall Street bears are getting in on the wager, reducing short bets on local currency funds to the lowest in more than four years, according to data compiled by Bloomberg. 

Outstanding bearish positions on the $3 billion VanEck Morgan EM Local Currency Bond exchange-traded fund fell to 0.69% of the float, the lowest since October 2019, according to data from S3 Partners.

A sweet spot remains in Latin America. Brazil’s central bank pushed up its key Selic rate earlier and higher than others, and has already started to ease that policy. Policymakers in Chile, Colombia and Peru have also started trimming rates.

In the coming days, three central banks in the region are expected to deliver cuts. Brazil’s first monetary policy decision of 2024 will likely result in a half-point reduction, while policymakers in Chile and Colombia are also projected to slash benchmark rates.

Even Mexican central bankers, who have kept their rate at a record 11.25% for six decisions, have started signaling eventual cuts. Most analysts expect the next move to be a quarter-point drop in March, according a recent Citigroup Inc. survey.

“Latin America continues to be the most attractive region for local-currency bonds, particularly Brazil and Mexico,” said Carlos de Sousa, a portfolio manager at Vontobel Asset Management AG. Once the Fed starts cutting rates, “that will encourage some of the more hawkish central banks — such as the central bank of Mexico — to also do the same. So they can do pretty well this year.”

Last year, local currency bonds from emerging markets handed investors a 6.4% return compared with 9.6% for hard currency debt, according to Bloomberg indexes.

Improving economic conditions and policy changes in countries including Turkey are also luring investors, said Claudia Calich, the head of emerging-market debt at M&G Investments in London, who pointed to a recent embrace of monetary orthodoxy. Turkey’s central bank raised interest rates for an eighth straight month last week and said it would keep them high for as long as needed.

“In local markets, which is an area we hadn’t been invested for quite some time, we finally now added some exposure on back of the central bank’s ongoing tightening,” Calich said.

WHAT TO WATCH

• In Brazil, Bloomberg Economics expects the first monetary policy decision of 2024 to lead to a rate cut.
• Chile’s central bank will likely cut its benchmark rate to 7.25% from 8.25%, a larger move after lower-than-projected inflation through December. Policymakers in Colombia may lower rates to 12.75% from 13%.
• China’s official PMI surveys for January are likely to show activity revving up before the Lunar New Year holiday, according to Bloomberg Economics.
• Central banks in Pakistan and Singapore are both forecast to leave their key rates on hold.