In emerging markets with high real yields (like EMEA and LATAM), central banks are responding to rapid currency appreciation by leaning towards monetary policy easing, such as rate cuts. This is seen as a more effective and tradable reaction than direct FX market intervention.
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Emerging market central banks' hawkish commentary while cutting rates reinforces market stability. This low volatility, in turn, gives them confidence to continue the cutting cycle. This feedback loop can make low-volatility periods surprisingly persistent, as the actions and outcomes mutually reinforce each other.
Emerging market monetary policy is diverging significantly. Markets now price in rate hikes for low-yielding countries like Colombia, Korea, and Czechia due to stalled disinflation. In contrast, high-yielding markets continue to offer attractive yield compression opportunities, representing the primary focus for investors in the space.
A recent global fixed income sell-off was not triggered by a single U.S. event but by a cascade of disparate actions from central banks and data releases in smaller economies like Australia, New Zealand, and Japan. This decentralized shift is an unusual dynamic for markets, leading to dollar weakness.
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.
Contrary to conventional wisdom, a rate cut is not automatically negative for a currency. In economies like Sweden or the Eurozone, a cut can be perceived as growth-positive, thereby supporting the currency. This contrasts with situations like New Zealand, where cuts are a response to poor data and are thus currency-negative, highlighting the importance of economic context.
The initiation of the Fed's cutting cycle is the critical trigger for a weaker dollar against EM currencies, outweighing any mixed forward-looking commentary. This is because the cycle's start begins to erode the US carry advantage, a key structural factor supporting EM FX performance.
In a significant role reversal, emerging market central banks were more proactive and aggressive in tightening monetary policy to combat post-COVID inflation than developed market institutions. This action demonstrates a secular improvement in their credibility and sovereign credit quality.
The Fed's recent hawkish comments are likely a communication strategy to manage market certainty about a December rate cut, rather than a fundamental policy shift. The firm's economist still anticipates a cut, and the market prices in three cuts over 12 months, suggesting the overall easing backdrop remains intact for Emerging Markets.
A significant split in monetary policy is expected in 2026. The US Federal Reserve and European Central Bank are predicted to cut rates in response to slowing growth and easing inflation. In stark contrast, the Bank of Japan is on a hiking cycle, aiming to reflate its economy.
The disinflationary impact from goods prices has largely run its course in emerging markets. The remaining inflation is concentrated in the service sector, which is sticky and less responsive to monetary policy. This structural shift means the broad rate-cutting cycle is nearing its end, as central banks have limited tools to address services inflation.