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Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
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Macro Insights: Chile kickstarts the EM easing cycle
Charu Chanana
Chief Investment Strategist
Summary: Chile announced a larger-than-expected rate cut, and is the first emerging market (EM) to jump on the easing bandwagon in the current cycle. The move could be a catalyst to kickstart a broader EM easing cycle, as they went early into the tightening cycles and brought inflation under control. Brazilian central bank meets on Wednesday and may follow suit, with more to follow in Latin America and Emerging Europe, while Emerging Asia may lag due to less aggressive rate hikes limiting the room. This could make EM equities and local currency bonds attractive.
The Board of the Central Bank of Chile decided to cut the monetary policy interest rate by 100bps to 10.25%. The decision was unanimous and considered dovish compared to expectations of a 75bps rate cut. Inflation has been falling faster than expected, while growth has held up in-line with the forecasts made at the June meeting. This provided ammunition to Chile’s central bank to be the first-mover and kickstart a rate-cut cycle to reverse the massive rate hikes it had to undertake during the pandemic which brought the interest rates from just 0.2% in mid-2021 to 11.25% in late 2022. The central bank has been on hold since then, potentially waiting for the Fed to give a clear pause signal, which happened at the July FOMC meeting where a clear data-dependent approach was adopted while not committing to any further rate hikes.
Other emerging markets could get a signal
The move from Chile’s central bank is likely to signal the start of a broad emerging market (EM) easing cycle, with Brazil set to follow suit this week as it meets on Wednesday and Peru, Mexico and Columbia also set to follow suit. Brazil’s Selic rate is currently at 13.75%, having rise from a low of 2% at end-2020. Brazil’s rate hike cycle has been the steepest globally, providing the most room for easing over the next two years. Meanwhile, inflation has dropped to 3.2% YoY in July from a peak of over 12% YoY last year.
Some countries in EM Europe such as Czech Republic, Hungary and Poland have also been on pause longer-than-average and could take a signal from Chile’s announcements. Emerging markets in Asia could lag in the current rate cut cycle as their tightening moves were less aggressive in the current cycle with inflation pressures remaining less concerning. Still, India, South Korea and Indonesia could consider cutting rates by the end of the year if inflation continues to slow.
Where are the opportunities?
The start of the easing cycle in emerging markets could support EM financial markets, adding to recent gains in local currency bonds and brightening the outlook for EM equities further ahead. Local currency bonds in Latin America may be preferred over other emerging markets as central banks in the region have most room to cut rates. LatAm currencies have also posted strong gains this year as investors took advantage of the carry trade opportunity.
While the carry may still remain attractive due to the interest-rate spread and a weakening dollar trend, there may be reasons to be cautious given high valuations and the turning rate cycles which, if aggressive, can lead to capital flight.
Risks to the view
A slowing inflation outlook is the key to EM rate cut cycles getting started. An inflation shock, from either climate change or geopolitical tensions, could upend the inflation trajectory. Recession risks in US and Europe, along with a slowing China economy, also presents risks to the scope of improvement in economic activity that can be driven by the rate cut cycle. Another risk is that markets have already priced in the easing across emerging markets and valuations may be unattractive. Carry trades also remain at risk with Bank of Japan showing flexibility on its monetary policy, given Japanese yen has been a key funding currency that helped power BRL and MXN. This could limit the pace of the easing cycle by EMs as they do not want to disrupt the carry trade advantage.
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