This analysis is by Bloomberg Intelligence Chief EM Credit Strategist Damian Sassower. It appeared first on the Bloomberg Terminal.
Emerging market local-currency debt is off to its best start since 2019, as foreign creditors benefit from falling yields and a weaker dollar. Duration should continue to support EM local government debt returns, as softer growth and slower inflation take root amid considerable divergence in yield differentials.
EM local bonds off to best start since 2019
EM local-currency debt is off to its best start since 2019, as falling yields and a weaker dollar fuel year-to-date performance. Softer growth and inflation expectations have driven duration gains (orange) of 181 bps for the year, with 15 of 18 countries contributing positively over the period. Local-currency appreciation (blue) is responsible for another 182 bps of positive attribution, yet only 11 of 18 currencies are up this year vs. the greenback. Carry has risen materially in recent quarters and now totals 324 bps for the year.
Duration measures the level, slope and shape of local-government yield curves. Currency reflects the change in performance attributed to the movements in spot foreign-exchange rates. Carry refers to coupon income.
Duration starts to deliver in EM local debt
Duration should continue to contribute positively to EM local-debt returns as softer growth and slower inflation take root amid considerable divergence in yield differentials. EM central banks have hiked policy rates by a combined 11,120 bps since the tightening cycle began in 3Q20, leaving local yield curves inverted in Chile, the Czech Republic, Hungary, Israel, Mexico and Poland. Indonesia (52 bps) has delivered the largest contribution to return from duration this year, followed by Brazil (45 bps), Colombia (36 bps), Poland (20 bps) and Malaysia (19 bps).
The relationship between US yields and EM local-debt performance is strong, as the contribution to returns from duration (movement in local yields) exhibits a 85.1% correlation to the 10-year Treasury (r-squared: 72.4%), based on 10 years of daily data.
Yuan weakness leaves EM currencies vulnerable
Continued dollar-yuan strength leaves Asian currencies vulnerable to correction, yet an inverted US real-yield curve is supportive for emerging market foreign exchange. Since falling to a record low in October, the Bloomberg EM Equal-Weight Spot FX Index is up 7.8%, with high yielders (e.g. Hungarian forint, Chilean and Colombian pesos) leading the way. EM currency performance is now flat over the past year, with the Turkish lira (minus 36.1%), South African rand (minus 14.1%), Chinese yuan (minus 7.8%) and Israeli shekel (minus 6.4%) trailing peers.
The relationship between the US dollar and EM local debt performance remains strong, as contribution to return from currency movement exhibits an 86.3% correlation to the Bloomberg Dollar Spot Index (r-squared: 74.4%), based on 10 years of daily data.
