In recent years, the global economic landscape has undergone significant changes, especially following the turbulent events of the pandemic and the subsequent recovery efforts by governments worldwideCentral banks across the globe have strategically implemented tightening monetary and fiscal policies, marking a distinctive feature of the current economic cycle: the uncertainty surrounding the peak of interest ratesThis uncertainty has raised pertinent questions regarding future economic stability and growth, particularly in emerging markets.

Emerging markets, often seen as the backbone of global growth, are now facing a conundrum as inflationary pressures begin to show signs of moderationVarious factors indicate that inflation in these economies is likely to slow down, prompting many central banks in these regions to potentially reach the zenith of their interest rate cycles

With the market having accounted for the likelihood of central banks maintaining current rates and eventually lowering them, investors are increasingly focusing on the abundant investment opportunities available within local bonds in these emerging markets.

However, the ever-evolving inflation scenario brings forth critical questions: What will be the trajectory of central bank policy rates in emerging markets? When will these banks adjust their rates, and how will investments be influenced in this shifting landscape?

Anticipation of Rate Cuts

As central banks in emerging markets accelerated their rate hike cycles, particularly from May 2022 onwards, it is not surprising that the market now anticipates potential rate cuts in the coming months to a couple of years

For many emerging market central banks that commenced their rate hikes as early as the latter half of 2021 or early 2022, the pricing reflects varying timelines and frequencies of expected cuts across different countriesGenerally, market pricing for future rate cuts is influenced by factors, including the starting point of the hiking period, the total number of rate increases to date, and the projected trend for long-term neutral policy interest rates.

Moreover, given that the market has largely absorbed expectations that the U.SFederal Reserve might cut rates by 225 basis points over the next two years, the possibility of looser monetary policy in the U.Smay diminish the strength of the dollar while easing downward pressure on emerging market currenciesThis could significantly mitigate inflationary pressures and policy rates in emerging markets.

Histories of Rate Hikes Post-Crisis

Taking a broader historical perspective, once policy rates remain sufficiently restrictive over a long-term horizon, the typical next step involves entering a period of monetary easing

It is common for central banks in emerging markets to elevate interest rates to their peak 6 to 12 months—or even longer—before initiating a cycle of easingFurthermore, the higher the policy rate relative to a nation's long-term neutral rate, alongside a prolonged pause in rate hikes, the longer the ensuing easing cycle tends to lastHistorically, the scale of monetary easing is often at least 50% of the total amount by which rates were previously raised.

For instance, Thailand maintained its rate unchanged for just two months in 2011 before slashing it by 200 basis points to 1.5%. In contrast, South Korea kept its benchmark rate at 3.25% for nearly a year after implementing 125 basis points of increases from 2010 to 2011, eventually reducing the rate by 75 basis points.

Evaluating historical patterns can offer insights into current circumstances; as concerns about economic slowdowns loom large, the yield curves in regions such as Latin America, Eastern Europe, and Africa indicate substantial room for rate cuts, potentially aligning with lower long-term levels

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This scenario underscores the driving forces behind this asset class and the logic of making long-term investmentsThe pressing question, therefore, is how to identify which curves are suitable for long-term investment.

The Current Cycle of Rate Increases

As we navigate the unfolding of the current economic cycle, countries that initiated policy tightening first, halted rate hikes, or turned to significant increases earlier may emerge as preferred long-term investment destinationsInvesting long-term in such nations could not only provide opportunities for positive real yields as inflation pressures wane but also deliver attractive total returns as yields decline in response to subsequent cuts.

In comparison to Latin American nations and countries in Central Europe, many Asian economies have been minimally affected by the global surge in inflation

For instance, the spillover effects of deflation in China may influence monetary policy decisions in parts of Asia, such as Indonesia, South Korea, and Thailand.

That said, South Korea currently stands out as an exception within the Asian regionSince 2021, the South Korean central bank has raised its policy rate by 300 basis points to reach 3.5%, the highest level seen since the global financial crisisProjections suggest that South Korea may only cut rates by 50 basis points in the next two years, making the risk-return profile favorable for investments in the mid-range of the interest rate swap curveIndonesia, on the other hand, has performed exceptionally well in this current tightening cycle and has only increased rates by 225 basis points to 5.75%, thanks to advantageous trade conditions and weakened internal demandWe remain optimistic about Indonesian local bonds, given that potential rate cuts in the latter half of 2023 could provide additional momentum for long-term structural growth.

Conversely, Malaysia's rate hikes were relatively late and gradual, with the most recent increase in May catching the market off guard

Thus, when investing in countries that began hiking rates late and progressed slowly, the optimal strategy would be to reduce holdings in short-term bondsThailand's situation is somewhat similarDespite a steep yield curve, the Bank of Thailand raised its policy rate to 2% in MayEven with the conclusion of its tightening cycle, the country's lower yield levels compared to others present considerable resistance to further yield compression.

Since the COVID-19 pandemic, the outlook for local bond markets in emerging economies has remained quite flexible, and central banks in these markets tightening monetary policy has provisionally secured short-term bond investmentsFrom an inflation standpoint, with a gradual slowdown in prices, the aggressive rate-hiking strategies adopted seem beneficial across various nationsAfter analyzing the potential scope for cuts, we predict opportunities for growth in nations that appear to have sufficient space to relax policies