Traders of emerging-market debt have a new challenge: predicting which central banks will be first to stop rate rises, and then buying bonds from those countries.
While that might sound premature to investors digesting the Federal Reserve’s first interest-rate increase since 2018, Latin America has emerged as the front-runner in this high-stakes game after nations in the region began aggressive tightening about a year ago.
Brazil indicated a rise in May would probably be its last after boosting rates almost 10 percentage points in 13 months.
And central banks in Chile and Colombia raised borrowing costs last month by less than economists forecast.
Higher-than-expected inflation might still derail this shift but the promise of “peak hike” for certain nations in the region has BNP Paribas Asset Management and PineBridge Investments predicting curves will steepen in Latin America, creating opportunities in shorter-maturity debt.
Goldman Sachs Group is recommending steepeners — a strategy in which investors bet on short-term bonds rather then longer-dated ones — particularly in Brazil and Chile.
“We expect some Latin American central banks to start slowing the pace of their hiking cycle as we think they are getting closer to their terminal rates,” said Clement Niel, a fund manager at BNP Paribas Asset Management in London.
“Curves should start bull steepening as inflation slows down and central banks start considering rate cuts.”
The contrast with emerging markets in Asia couldn’t be more stark.
Central banks in India, Malaysia, Indonesia, Thailand and the Philippines are expected to only start raising rates in the second half of this year, according to the median estimate of economists surveyed by Bloomberg.
Policy tightening is likely to weigh on shorter-maturity bonds and flatten the yield curve.
In Europe, while policy makers in Poland, Hungary and the Czech Republic have already raised rates above pre-pandemic levels, they are set to stay hawkish as their proximity to the war in Ukraine is adding extra uncertainty to their economic outlook and causing the prices of their energy imports to surge.
Both of these factors are negative for their bonds.
That has put the focus firmly on Latin America, where yield curves have plenty of room to steepen given they are now below their long-term averages.
The shorter end of the Brazilian yield curve is inverted, with two-year yields more than 70 basis points higher than five-year, compared with the average spread of positive 147 basis points since April 2017.
The two-five spread in Mexico is about 10 basis points, below the long-term average of 24.
“Signals of slower tightening, if not a pause, by Latin American central banks engaged in more mature hiking cycles, primarily Brazil and Chile, may leave room for more steepening than currently priced, in line with historical patterns post emerging-market yield-curve inversions,” Goldman Sachs strategists Davide Crosilla and Kamakshya Trivedi in London, wrote in a research note last month.
For others such as Cathy Hepworth, head of emerging markets debt at PGIM Fixed Income in Newark, it is really difficult to make the call that Latin America is at the end of its cycle, because headline and core inflation are drifting to multi-year highs.
“What you have to do is continue to focus on flatteners because it’s too much of a challenge,” Ms Hepworth said. “The margin of error is way too high to call for peak inflation.
"So therefore, being on the front-end of the curve is risky, and if you’re comfortable that at least some positions further out in the curve price in excessive hikes, then that would argue for the flattener position.”
Strengthening regional currencies are also giving Latin American policy makers scope to curtail rises by helping to suppress imported inflation.
Five of the six best-performing emerging-market currencies this year are from Latin America, in part thanks to the rally in commodities that has benefited these resource-rich nations.
“The surprise strength in Latin American currencies in the face of geopolitical risk and a hawkish Federal Reserve may enable central banks to tighten less than warranted by short-term inflation fears,” said Anders Faergemann, a senior portfolio manager at PineBridge Investments in London.
“The unexpected appreciation of exchange rates should lead Latin American central banks to take the foot off the pedal sooner than the market currently expects.”