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The most attractive real yields in EM as SVB collapse raises chance of Fed pivot

  • Markets are now pricing in a markedly more dovish Fed rate path post-SVB crisis, but we think repricing is excessive

  • Still, the prospects of marginally lower terminal Fed funds rate and weaker dollar could support EM local currency debt

  • We survey real 10-year yields across 32 EM, with Brazil, Uganda and South Africa standing out as particularly attractive

The most attractive real yields in EM as SVB collapse raises chance of Fed pivot
Tellimer Research
16 March 2023
Published byTellimer Research

All attention this week has been focused on the collapse of Silicon Valley Bank and the potential ramifications for the Fed’s ongoing hiking cycle and global financial conditions more broadly. As of Wednesday, markets were pricing in an aggressively dovish pivot by the Fed, with an implied hike of just 10bps this month, followed by 100bps of cuts through year-end (30bps and 180bps lower than a week ago, respectively).

At first glance, this seems excessive – the need to fight inflation has not gone away, and it seems unlikely (thus far) that banking sector issues will lead to a real economy impact that would dampen inflationary pressures, which should prevent a wholesale reversal by the Fed until there is more durable evidence of disinflation and/or a sharp rise in unemployment (see here for our detailed views on the topic pre-SVB).

WIRP

That said, higher risk premiums in specific sectors like banks and high-yield credit more generally will likely contribute to tighter financial conditions in the coming months, which could still lead to a slightly lower terminal rate relative to our pre-SVB outlook and could lower the bar for cuts in the future. This could lead to a weaker dollar and higher real interest rate differentials between emerging markets and the US, which would benefit EM local currency debt.

With median inflation falling by 90bps over the past six months and 44% of the countries in our 66-country sample continuing their hiking cycles so far this year, the median EM real policy rate has now risen by 250bps from the June 2022 trough. However, a more rapid decrease in inflation and steeper rate hikes in the US has eroded the EM-US real rate differential. A dovish shift in the US, though, could reverse this trend.

EM real rates

Real rate differential

Against this backdrop, we take a brief look at which countries have the most attractive real yields on 10-year government debt across a sample of 32 emerging and frontier markets. We focus on 10-year debt to account for both expected inflation and term premium, taking a slightly longer-term view than simply screening short-term rates for carry trade attractiveness. Further, with market rates diverging widely from policy rates in many EM, we prefer to use a market yield rather than comparing real policy rates (which more than halves our sample but results in more actionable insights).

Within our sample, the highest real yields are in Ghana (20.8%), Ukraine (19.6%) and Zambia (17.8%), each of which is in distress, with Ghana having recently restructured its domestic debt and an increasing risk that domestic debt held by non-residents is included in Zambia’s ongoing restructuring.

Real rates

Among the non-distressed countries, the highest real yields are in Brazil (7.5%), Uganda (6.3%), Kenya (4.8%), Namibia (4.6%), South Africa (4.3%) and Panama (3.3%). The rest of the sample has either marginally positive or negative real yields, with 18 of the 32 countries currently showing negative real yields and a median real yield of -0.9% across the sample.

Among the countries above, we think Uganda is the most attractive and currently have a Buy rating on 10-year domestic government debt in Uganda, with a nominal yield of 15.5% and a real yield of 6.3%. The trade is also not very crowded, with non-residents holding just US$600mn of government debt (c7% of the total, of which 90% is in bonds). It also has a positive macro story, with strong growth and debt on a declining path from a relatively low base. However, it is very illiquid so may not be suitable for larger funds, and there is some risk that UGX is overvalued.

Despite a relatively high nominal yield of 14% and real yield of 4.8%, we have doubts about Kenya’s ability to meet its external financing needs and think more KES depreciation and rate hikes are necessary to prevent a balance of payments crisis. As such, we do not think real yields are sufficiently high to compensate for this risk.

In South Africa, a real yield of 4.3% is topped only by Brazil in the liquid EM space and a uniquely steep yield curve contributes to attractive nominal rates of 11.3% (versus just 6% for the two-year). However, with ZAR trading as an EM proxy and risk aversion likely to remain elevated in the near term as markets digest a more hawkish Fed rate cycle and SVB-related uncertainty, we think investors are better off waiting until the terminal Fed funds rate is in the rearview before going long ZAR and will continue to monitor external and domestic conditions for a better entry point.

We do not currently have a rating on the other three countries (Brazil, Namibia and Panama), although Namibia’s currency is pegged to ZAR (linking its monetary policy as well) and offers a 40bps nominal and 30bps real yield pickup for what is effectively ZAR risk but at the cost of far lower liquidity, leading us to favour ZAR.