Best days over for emerging market local currency bonds?

May 15, 2013

Local currency bonds in emerging markets, like most financial assets, have enjoyed a solid rally on the back of ample global central bank liquidity. But the good times may be coming to an end, according to a report from Capital Economics. That’s because there’s only so much boost the securities can get out of the monetary easing efforts of the Federal Reserve and other major central banks, the firm says.

Emerging market (EM) local currency government bond yields have fallen sharply in the past few years. Our GDP-weighted overall 10-year yield of a sample of 18 EM sovereign borrowers has dropped by 125 basis points since the start of 2011, to around 4.4% at the end of April.

Our calculations suggest that almost the entire decline in the yield has been due to a drop in the risk-free rate rather than in the credit spread. And since the risk-free rate reflects long-term expectations for monetary policy, this suggests that the fate of EM local currency bonds will depend to a large extent on how short-term rates evolve.

The recent trend has been for central banks to loosen monetary policy further and we generally expect policy rates to remain low throughout our forecast window. However, of the 18 countries in our sample, we forecast that by the end of next year the benchmark policy rate will actually be higher in 10 cases, the same in 5 cases, and lower in only 3 cases. We expect some rise in rates in the Emerging Asia and Latin America regions to be offset only partly by a drop in rates in Emerging Europe.

Accordingly, we think the best days for EM local currency bonds may now be over. After all, the risk-free component of our 10-year overall yield seems unlikely to fall further if we are right to expect some small rise in policy rates on average, even if we forecast rates to rise by less than the consensus.

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