Despite analysts' neutral stance, EM local rates outperformed expectations. The Fed's hawkishness flattened the US Treasury yield curve, causing the long end to perform better. This unexpected dynamic pulled EM government bond yields lower, delivering gains for investors in local rates.

The stability of emerging market risk assets hinges on the U.S. Federal Reserve's contained reaction to oil price shocks. By not aggressively tightening policy, the Fed avoids exacerbating the shock for EM economies. This "asymmetric reaction function" allows other central banks to maintain a slower, less growth-restrictive policy response.

A more aggressive Federal Reserve reaction function is interpreted as a tightening signal by inflation markets. This leads to lower inflation break-evens and higher real yields, a counter-intuitive move compared to when the Fed and markets react in tandem to strong economic data.

Not all Fed tightening cycles are equally damaging to Emerging Market currencies. The most painful periods for EM FX occur when Fed policy repricings cause US *real yields* to rise materially, rather than just nominal rates or inflation break-evens. The current ambiguity in this mix provides a temporary shield for EM currencies.

The firm's analysts anticipate persistent core inflation in select emerging markets, suggesting an end to easing cycles. This contrasts sharply with clients who expect further disinflation driven by pressures from China and energy prices, marking a key area of disagreement on the global economic outlook.

While a stronger growth environment supports EM currencies, it is problematic for low-yielding EM government bonds. Their valuations were based on aggressive local central bank easing cycles which now have less scope to continue, especially with a potentially shallower Fed cutting cycle, making them vulnerable to a correction.

The current US rates sell-off is characterized by rising real yields rather than just higher inflation expectations. This specific type of move is the most damaging for emerging markets because it tightens global financial conditions, making it difficult for EM rates to decouple from US pressure.

A potential drop in oil prices may cool headline inflation, but it won't necessarily stop Emerging Market central banks from tightening. Underlying price pressures from sticky services inflation, strong demand, and supply bottlenecks will keep core inflation elevated, maintaining the bias towards further rate hikes.

Unlike the 2022 energy shock post-Ukraine invasion, the current market is not emerging from a decade of zero interest rates. U.S. real rates are already positive, and EM economies have built up buffers after being stress-tested, making a repeat of 2022's widespread defaults less likely.