Higher rates in core market rates triggered higher local rates across emerging markets; in segments such as higher-yielding local markets, we believe the adjustment appears excessive.

At first sight, the yield increase in emerging markets local bonds so far this year is not significantly out of line with what we saw in developed markets. Only in February and March, when U.S. real yields started to move higher more meaningfully, did the underperformance of both EM FX and local rates become more pronounced. However, the dispersion among the 19 countries represented in JP Morgan’s GBI EM Global Diversified index is significant. Where the average index yield moved wider by 73 basis points (versus the five-year U.S. Treasury’s 41bps move), some low-beta countries like China, Romania and the Dominican Republic saw yields moving sideways or even lower. Most other low- and mid-yielding EM countries, predominantly in Asia and Central Europe, moved in tandem with core markets.

The generic theme here was that, with the cyclical recovery gaining strength and inflationary pressures building, yields adjusted higher. In some cases (the Czech Republic, Hungary and South Korea), central banks are already expected to tighten monetary policy. Most other Asian central banks see no reason yet to abandon their easy monetary stance as long as the number of COVID cases remains elevated, and as long as (core) inflationary pressures remain muted. Yields in the long end of the curve went higher, pressured by ongoing fiscal stimulus and increased issuance.

In contrast, the sell-off across EM high yielders has been much more disorderly. The combination of higher core market yields, (supply-side) inflationary pressures, fiscal underperformance and idiosyncratic (in most cases politically motivated) drivers triggered a significant repricing of risk premia in the curves of Turkey (+498bps), Brazil (+246bps) and Colombia (+171bps) and, to a lesser extent, Peru, Chile, Mexico and Russia. The front end and belly of curves started to factor in a full hiking cycle, but also (real) rates further out on the curve moved considerably wider. The magnitude of the move is remarkable when taking into account more favorable factors such as the considerable slack in most economies after the COVID-induced collapse of 2020, supportive commodity prices and transitory inflationary pressures as base effects kick in later this year.

Going forward, core market developments are likely to be more gradual than the pattern seen earlier this year, reducing volatility. The sizeable risk premium in various cases captures expected rate hikes, but also liquidity and real risk premia that weren’t there earlier (e.g., 10-year real yield in Mexico at 2.6%, Russia, 3.1% and Indonesia, 3.4%). Due to these factors, we have upgraded our outlook for local bonds with an emphasis on higher-yielding rate markets.