LONDON Bond fund managers who have been banking on deep interest rate cuts in emerging markets risk disappointment as steep falls in currencies and still-sticky inflation could prompt central banks to postpone policy easing.
The sector has benefited hugely from the growth scare engulfing the world, as markets bet a year-long credit-tightening cycle is on the cusp of reversal. That brought a rush of cash to EM local bonds over August, when most other assets sold off -- the rally shaved on average almost 1 percentage point off five-year EM yields, Goldman Sachs estimates.
That inflow may have peaked. A serious pickup in risk aversion this week has seen investors flee emerging markets in favour of more liquid dollar assets, pushing currencies across the developing world to multi-month or even multi-year lows.
Some markets such as South Africa and Hungary have seen short-dated bond yields rise 60 basis points or more and the benchmark local bond index, JPMorgan's GBI-EM, has seen unhedged returns fall over 5 percent this month.
The latest developments are a blow to investors' conviction that central banks in the developing world are gearing up for big rate cuts to support growth.
"We are worried about the price action in EM currencies," said Guillaume Salomon, strategist at Societe Generale. "Currency weakness will put upward pressure on inflation expectations but the market still remains priced for rate cuts."
He said the currency selloff had prompted SocGen to exit most receiving -- or long -- positions in EM fixed income.
Interest rate swaps, used for betting on changes in interest rates, have swung from predicting rate rises in emerging markets
a few weeks ago to discounting big rate cuts almost everywhere.
These bets kicked off after a trailblazing half point cut by Turkey on August 4 and picked up speed when Brazil surprised with a 50 basis point rate cut three weeks later.
Investors reckon stuttering Western growth and the increased likelihood of more monetary easing from Europe and the United States will leave EM policymakers little choice but to step to the defence of their economies and currencies via rate cuts.
But the pendulum may have swung too far, with many seeing the re-pricing on swaps markets as excessive.
"I am not convinced all these rate cuts will actually happen," said Kieran Curtis, who helps to manage $1.4 billion in local emerging debt at Aviva. "I would say we are talking about stable (rates) for longer rather than sustained rate cuts."
India on Friday failed to pause its 18-month long tightening cycle, raising rates by 25 basis points. Chile too did not follow Brazil's example, holding rates steady at this week's policy meeting. Analysts now expect Chile to raise rates next year, though swaps predict a quarter point cut by year-end.
The currency selloff will also force investors "to re-assess the inflation outlook and the extent to which some EM central banks can cut rates in the short term," Salomon of SocGen said.
The crux of the matter is that despite slowing growth the inflation genie hasn't gone back into the bottle. Above-target price pressures almost everywhere will make it hard for central banks to deliver all the rate cuts swaps are predicting.
Brazil's August rate cut came as inflation hit six-year highs above 7 percent. Inflation in China and Korea is at three-year highs and even Poland, at risk from the euro zone meltdown, is seeing price growth almost double the central bank target.
"Some of the inflation pressure is off but under normal circumstances we would not be pricing rate cuts off current levels," Aviva's Curtis said.
And because monetary and fiscal policy has been loose for so
long, inflation expectations are unlikely to moderate as fast as central banks would like. Any extra stimulus from the West will almost certainly push up commodity prices further.
India is an example of how swaps may be mispricing policy. It is tipped for almost 100 bps of policy easing in the coming year even though the central bank has repeatedly signalled its determination to curb inflation. The rupee's fall to 15-month lows will further complicate that task.
Similarly in Poland, a 50 bps cut is priced in. But with the zloty at two-year lows against the euro and a quarter of public debt denominated in foreign currencies, the central bank may not dare to weaken its zloty currency further.
Big cuts priced priced by the Indian and Polish curve look unjustified, UBS analysts said, adding: "Expecting larger rate cuts than what's already priced in from EM central banks across all regions may be a loss-making proposition.
They warned: "If future growth fears prove unjustified and EM central banks bend to political pressure to support growth and accommodate inflation, they may be sowing the seeds for a significant weakening in the EM fixed income bid in future."
(Graphics by Scott Barber; Editing by Catherine Evans)