EM central banks are advancing in their policy tightening cycle, well ahead of the Fed that has signalled a potential lift-off in 2023 (FOMC announcement (Jun): Getting more confident, 16 June 2021). Central banks in Czech, Hungary and Mexico have joined the ranks of Brazil and Russia by hiking policy rates. This hawkish pivot by EM central banks means that duration exposure in EM local rates remains exposed to risks of a further building of term premium. Pockets of value are emerging in several markets and differentiation is needed to position in EM local debt.

Pockets of value are emerging for taking duration risks In markets that have front-loaded policy rate hikes or indicated intentions to normalise policy soon, implied policy rates have already entered into overtightening territory and/or forwards rates have reached levels that are above the expected values of terminal rates in those markets. In our view, it is now time to capture the risk premium at the long-end of the curve in such cases, especially in markets that exhibit lower beta sensitivities to any adverse change in appetite for EM risk (i.e., EM low yielders such as Korea and Czech) and in markets where macro fundamentals are relatively strong (Russia) and valuations are cheap (South Africa). In contrast, we believe it is too early to position in markets where macro risks are still intensifying even if they have moved early into a tightening cycle, such as in Brazil and Mexico.

We also have a strategic long duration stance in China (buy 30Y CGBs) where longdated rates are less exposed to risks of any global policy normalisation.

Stay cautious on those falling behind the curve Finally, there are markets where central banks appear to be “behind the curve”, maintaining an accommodative policy stance despite rising inflationary pressure (e.g., India and the Philippines). Local rates remain exposed to risks of sharper adjustment enforced by market forces. We therefore maintain our cautious stance on duration in these markets.

Trickier to capture front-end risk premium in an EM hiking cycle It is more complicated to receive rates at the front-end considering that short-dated risk premium tends to overshoot going into a hiking cycle. Yet, we see opportunities to receive in low-yielding markets such as Poland (selling PLN 12x15 FRA).