Emerging Market Local Debt: Souring Bets Amidst Dollar Strength and Trade Tariffs

Outlook

A promising start for emerging market local debt has turned sour due to a strengthening dollar and the impact of US tariffs. This has prompted fund managers to reconsider their exposure to developing assets.

Cautious Investors

In the face of a hawkish Federal Reserve and President Donald Trump's trade war, investors are skeptical about a turning point in rates. Chile, Sri Lanka, and Hungary have all held rates recently, citing inflation concerns.

Dollar's Impact

Trump's tariffs on Canada, Mexico, and China are complicating the outlook for emerging markets by boosting the greenback and potentially weakening their currencies.

Fund Flows and Short Selling

Despite small inflows, investors have pulled almost a billion from local currency bond funds this year. US short sellers are also targeting local-currency sovereign bonds in emerging markets.

Attractiveness of Hard Currency Debt

Yields on local-currency bonds in developing economies are facing competition from US Treasuries and hard-currency debt. Investors are favoring hard currency bonds due to the risk-adjusted basis.

Central Bank Decisions

Uncertainty surrounding US rates and tariffs is also influencing central bankers in developing countries. While most currencies have gained since Trump took office, they could serve as a "relief valve" for potential pressure. Chile and Colombia have recently paused rate cuts due to concerns over the fiscal deficit and inflation.

Trade Tensions

Fears that Trump's economic measures could boost the dollar and fan inflation are dimming the prospects for developing economies. The specter of higher tariffs is particularly concerning for export-dependent markets.

Opportunities for Volatility

Despite the volatility, some investors see opportunities in cheap currency valuations, particularly in Latin America. However, others remain cautious on Asian FX.

Watch

Investors should monitor rate decisions in Mexico, India, and Poland. The Reserve Bank of India is expected to start an easing cycle. Traders will also watch consumer price data in key emerging market economies.