Bond Voyage

Read this article to understand:

• Why the US dollar could stop hindering the performance of EM local currency debt
• How well-positioned many EM economies are
• Whether EM central banks can decouple from the Federal Reserve

EM local currency debt: From overlooked to overdue

The GBI-EM local currency benchmark index has gained more than 10 per cent year-to-date. A combination of attractive valuations, high real rates and external tailwinds mean that this rally should have further to run.

While a weaker US dollar is central to this, sound macro policies in many EMs have also contributed as they have allowed central banks to continue easing monetary policy amid a benign inflationary backdrop.

The dollar can finally stop being such a drag

Investors have historically been reluctant to allocate capital more significantly to EM local currency debt. This is in some ways understandable. After all, the strength of the US dollar over the past few years has been the single largest detractor of total returns for the asset class. Indeed, foreign exchange (FX) returns have been negative in 11 out of the past 20 years.

Of course, EMs have been through their fair share of crises – from idiosyncratic balance of payments shocks to broader external ones like COVID-19 and Russia’s invasion of Ukraine. However, the overall backdrop has been dominated by the dollar wrecking ball.

But things appear to be shifting. The dollar’s strength, once underpinned by US exceptionalism and safe-haven demand, is now undermined by growing fiscal imbalances, policy uncertainty, and geopolitical tensions – decidedly “EM-like” characteristics.

In parallel, President Trump’s new term has reignited trade war fears and raised questions about the reliability of US economic policy, further diminishing the appeal of dollar-denominated assets amid strong geopolitical headwinds.

We think this is more than just a tactical shift. The end of a dollar bull cycle has typically spurred capital flows into EM, specifically into local currency-denominated bonds. In fact, not only does EM debt historically outperform in both absolute and relative terms in a falling dollar environment, but it also tends to outperform in a “sideways” or consolidation period. This is as the currency impact becomes more muted and the higher nominal and real interest rates on offer in the local bond space dominate. Figures 1 and 2 show the various cycles in the US currency since the start of the century.

What’s more, the cyclical position of many EM economies favours currency appreciation. EM growth differentials relative to developed markets are set to widen in coming quarters. And external fundamentals are more robust, evidenced by record levels of FX reserves in many EMs. This trend is reinforced by the growing appeal of EM currencies themselves. Countries like India, Brazil, Mexico, and Poland are well-positioned to benefit from global supply chain realignments, regional integration, and increased demand for commodities and manufactured goods. As equity inflows rise and domestic savings deepen, EM currencies are gaining resilience and strength.

Between a rock and a soft place

On the local currency side, a weaker dollar benefits EM as it translates into reduced inflationary pressures for local economies, creating the space for deeper rate cuts by EM central banks. The disinflation trend since 2022 remains intact in EM, with inflation approaching target levels in many economies. Stronger currencies and lower commodity prices are providing an offset to some stickiness in services inflation.

And for many EM central banks, the gap between ex-ante real policy rates and neutral rates far exceeds the gap between inflation and targets on a one-year forward basis (see Figure 3). This offers particularly attractive scope for further easing in Brazil, Colombia, South Africa, and Hungary. 

But can EM central banks really be independent from the Federal Reserve (Fed) in this cycle?

The market has swung between pricing a US recession and significant rate cuts by the Fed to acknowledging that more resilient hard data may necessitate only one or two rates cuts this year. Previously, rate differentials have imposed a constraint on EM central banks’ reaction functions, primarily through concern over implied currency weakness. But now, the Fed may be less of a binding factor: current real rate buffers in EM are too high relative to the underlying macro cycle and are lingering near historical highs across the board. Latin America, in particular stands out, as a region in which duration screens as attractive.

When orthodoxy is your friend

Beyond the macro tailwinds, EMs have undergone significant structural improvements that enhance the appeal of local currency debt. Over the past decade, many EM governments have implemented prudent fiscal policies, strengthened monetary frameworks, and improved coordination between policy levers.

More importantly, policymakers have largely remained committed to orthodox measures, even under pressure. Whether by reacting to severe market/macroeconomic shocks with market-friendly measures (Turkey), staying resolute in the face of fiscal threats (Brazil, Colombia), or maintaining monetary prudence in the face of external uncertainties (Hungary, South Africa, Poland), central banks should inspire confidence that the policy credibility built up over the years is unlikely to be squandered.

One of the most underappreciated facts about emerging markets is the degree to which sovereign balance sheets and creditworthiness have improved over the past decade or so. We think this means that it is no longer plausible to assume that higher EM exposure equates to higher risk. This is especially relevant in a world in which fundamentals in developed markets are deteriorating.

Compared to other fixed income asset classes, especially similarly rated developed market bonds, EM local debt offers higher yield levels at lower levels of duration risk, and should be seen as an opportunity rather than a reflection of excessive risk (see Figure 4).