Market Sees Few EM Rate Cuts – Why?

Hawkish Fed

Headline inflation had peaked in most emerging markets (EM) by now, but the market expectations for EM rate cuts over the next 12 months look quite “stingy” in most regions (see chart below). Further, some analysts are now talking about the need for “insurance” rate hikes in some EMs. These include South Korea (the local swap curve prices in +40bps more), India (the market sees another 52bps in the current cycle) and South Africa (50bps more or so). Two major LATAM economies are also on the list – Mexico (+60bps more) and Colombia (+75bps more). An easy explanation is that EMs feel obliged to follow the U.S. Federal Reserve (Fed) – a more robust 2023 growth outlook and a series of upside inflation surprises pushed the U.S. peak rate forecast to 5.4-5.5% recently. Well, this might be the case in Mexico (a “nearshoring” argument), but we think local factors play a more important role elsewhere. 

Brazil Fiscal Outlook

Brazil is EM’s poster kid for successful disinflation (from 12.13% year-on-year to 5.77% in nine months). However, the fiscal policy uncertainty and new administration’s attempts to “convince” the central bank to lower the policy rate (in order to prop up growth) put the market (and the central bank) on the defensive. As of this morning, the local swap curve priced in only 95bps of rate cuts during the rest of the year. It is important to keep an eye on the new fiscal framework – the draft is expected to be finalized over the weekend – and what it means for the spending cap. The consensus sees the budget deficit widening from 4.7% of GDP in 2022 to 7.8% of GDP this year. But if the new framework looks credible, the market should see more room for policy easing before the year-end.

EM Policy Easing

One (local) reason behind various EM central banks’ caution is that underlying price pressures are often more persistent than headline, and core disinflation can take more time (a reflection of tight labor markets, for example). Central banks are also mindful of subsidy withdrawals, which is a good sign for the fiscal outlook but could result in “bumpy” disinflation progress. We do not see major problems with EM central banks’ cautious stance – especially if the growth outlook continues to improve at the margin. This combo provides a supportive backdrop for carry trades – additional Fed rate hikes notwithstanding – and leaves room for rates compression if disinflation progresses as expected (or faster). Stay tuned!

Chart at a Glance: EM Rate Cuts – Not Much Priced In

Source: VanEck Research; Bloomberg LP.