EM Divergent Rate Hikes and Coming Cuts

Figure 1: 10yr Government Bond Spread versus U.S. Treasuries (%) 

Source: Datastream/Continuum Economics 

Rate Hike and Cuts 

The picture across major EM countries remains divergent, with China cutting rates in June (here), S Africa deciding to halting the tightening cycle in July (here) and Russia hiking 100bps recently (here). EM remains dominated by domestic issues, rather than overspill of Fed and DM tightening as structural imbalances are less severe than 2013. Additionally, wide nominal bond spreads have provided a cushion for most major EM countries excluding China (Figure 1), which has signalled that domestic policy has not had to put Fed tightening and currency as the top priority for policy setting. Finally, major EM countries have been able to move inflation back towards targets better than some DM countries helped by more labor market slack (except for Mexico). Food inflation is however an upside risks in Asia due to El Nino (here).

EM currencies have also diverged through the course of 2023, with the Chinese Yuan (CNY) softer versus the USD despite the weaker trend of the USD against European currencies (Figure 2). At the other end of the scale, the short end interest rate differentials versus the U.S. have been so large, that carry trade flows have prompted a large appreciation for the Brazilian Real (BRL) and Mexican Peso (MXN) against the USD. Investors in long-dated bonds and equities have had bumper returns. In contrast, the South Africa Rand (ZAR) has been volatile against the USD, with a rebound in the last 2 months as the SARB is seen to regain control over inflation and as the fears of U.S. sanctions on S Africa for alleged arms sales to Russia have been downplayed by the U.S. (Note: ZAR gained 10.6% value against USD in the last two months.) Only the India Rupee (INR) has been broadly following the EURUSD pattern, as short-end rate differentials are narrower than for BRL or MXN.

Figure 2: Exchange Rate Changes Since Start of 2023 and end May versus USD (%)

Source: Bloomberg/Continuum Economics 

What now for EM policy and markets 

• China.China policy easing is driven by a desire to support the economic recovery against a backdrop that inflation is seriously undershooting PBOC desires for 3% (Figure 3). We look for negative inflation in the coming months, both due to base effects and as inflation momentum is low with production outstripping consumption goods and consumer services still recovering. This is not deflation and base effects should mean a return to positive inflation later in 2023. However, China policymakers are unlikely to ease policy aggressively, both as growth will likely exceed the 5% 2023 target and to avoid adding to high debt levels in China’s economy. What does appear on the table is a cut in the reserve requirement rate (RRR), which the recent PBOC mid-year briefing cited as a potential policy tool (here). We still feel that this could come in August, as it helps banks ability to lend. Even so, this is likely to be 25bps cut. In terms of policy rates the medium-term lending facility (MTF) was also cited as a potential policy tool. While an August move is possible, the focus appears to be more on September to deliver a further 10bps cut. One other reasons is that the authorities want to avoid hurting the Chinese Yuan too much by widening interest rate differentials still further against the USD. We do see a further 20bps of MTF cuts being delivered in H1 2024, but this only occurs as inflation takes longer to swing back into positive territory than the PBOC current thinking (here). The PBOC has also talked about a new policy tool, though this is unlikely to be PBOC QE of government bonds due to long running concerns over government financing by the PBOC. 

Figure 3: Yr/Yr CPI Inflation (%)

Source: Datastream/Continuum Economics 

• India. The slowdown in India CPI inflation has come to an end, as the delayed monsoon feeds in. Combined with concerns about upside risks to the trajectory, this leaves the Reserve Bank of India (RBI) inclined to be neutral and wait for the lags of previous tightening to feedthrough (here). This stance will likely remain through the remainder of 2023, before the RBI cautiously eases by a cumulative 75bps from 6.5% to 5.75% through 2024 (here). 
• S Africa.SARB split decision to keep rates on hold on July 20 leaves a tightening bias, but we feel that we are now at the rate peak given the slowdown in headline inflation in recent months to 5.4% (here). A quick switch to easing is unlikely given that SARB remains uncomfortable with inflation expectations and the CPI decline is projected to slow in H2. Instead, only in 2024 is the SARB likely to ease by a cumulative 75bps, which is largely designed to keep real policy rates from rising rather than any aggressive easing. Fiscal policy, electricity power cuts, financing needs, and upside inflation risks remain concerns for SARB, given the uncertainty around the 2024 general election scheduled between May and July. 
• Brazil. We have brought forward our forecast for the start of the easing cycle to the Aug 2 meeting (here). The recent further decline in headline inflation to 3% Yr/Yr and an overall improvement on the inflation outlook are helpful for the BCB to relax tight policy. Even so, with core inflation taking time to come down, the BCB will likely only cut by a cumulative 100bps in the remainder of 2023 from 13.75% to 12.75%. For 2024, we see the policy rate falling to 8.5% with the BCB easing consistently as core inflation comes down and converges to the 3% target.
• Mexico.Banxico policy guidance differs from Brazil, with the latest minutes pointing towards the need to keep policy tight (here). Though headline inflation has come down to 5.1% in Mexico, core inflation is proving more persistent and this is due to a tight labor market keeping wage inflation elevated (here). The Mexican economy is also linked to the U.S. economy, where the U.S. resilience helps support export volumes despite the MXN appreciation.Thus we see no cut from Banxico in 2023 and only see gradual easing in 2024 – we see the policy rate coming down from 11.25% to 9% by end 2024.

What are the consequence for major EM financial markets?

For local EM sovereign bond markets, future rate cuts in Brazil and China are helpful. However, China 2yr yields are already low (excluding the depth of the 2020 COVID crisis), while the scale of policy easing will be modest & gradual and this will stop any major decline in yields. This will keep the CNY soft but not falling sharply and we forecast 7.30 by end 2023 on USDCNY. Meanwhile, in Brazil the coming easing cycle will have echoes of 2009 not 2019/20 and 10yr yields will likely find it difficult to fall below 10% (Figure 4). This can slow foreign fund manager’s inflows at the long-end, though carry trades will still be attractive, and equity market upside remains good on an 18 month view (here). USDBRL has appreciated a lot and will likely run into profit-taking in late Q4, as the prospects of persistent rate cuts in 2024 comes into focus. We see USDBRL at 4.95 by end 2023. 

Figure 4: Brazil Selic Policy Rate and 2 and 10yr Yields (%)

Source: Datastream/Continuum Economics 

Steady policy in Mexico and India means different things for markets. The Mexican curve is so inverted due to restrictive policy that the lack of rate cuts will curtail further yield declines and more positive total returns. Even so, carry trade will probably still underpin the MXN in Q3, before the prospect of 2024 rate cuts prompt profit-taking and we see USDMXN at 18.50 end 2023. The relatively flat yield curve in India in contrast reflects the RBI’s decision to stop tightening at neutral rates and the government bond market will likely remain in a trading range for the rest of 2023. The same can be said for the INR, where we see USDINR at 81.90 by end 2023.

Finally, though South Africa 10yr yields would appear attractive given current real yields; the inflation trajectory and if the SARB would start cutting rates in 2024, a risk premia is required for S Africa assets. Until the 2024 election lifts uncertainty and a new government fixes the power cuts and solve logistical problems, financial markets will demand an extra risk premia. The ZAR has rallied too far and we look for USDZAR at 19.0 by end 2023, though most will likely come in the last 2 months of the year to reflect 2024 risks.