There has been an unexpected winner in the bond market in 2023: emerging market bonds. This is especially true for emerging market bonds priced in local currencies.

Currently, the gap in government borrowing costs between emerging markets and U.S. Treasuries is at its best level since 2000. The reason is that investors are pricing in imminent interest rate cuts in some big emerging economies, faster and deeper than in developed economies like the U.S.

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Better Central Banking?

This actually makes sense. There has been a large narrowing of the credibility gap between central bankers in the developing world, who never swallowed the bilge that inflation was “transitory” and central bankers in the west, who did. For example, the Central Bank of Brazil (a country not exactly known for prudent monetary policies), raised rates a year before the Federal Reserve moved. Today, it seems inflation in the country has been tamed, and is now falling. Inflation in Brazil was 3.2% year on year in June, just below the central bank target of 3.25%. Interest rates remain at more than 13%, so there a lot of room for cuts, which are expected soon.

Even in Mexico, inflation is falling. It was down to 5% year on year in June versus policy rates of more than 11%. So again, there is a lot of room for the country to cut rates and for bonds to gain in price.

And we are seeing this pattern repeate elsewhere in the developing world, which is why investors in emerging market bonds are taking note that inflation may now fall faster than emerging market central banks cut rates, generating steeper real yields on local debt. The reality is that central banks in Latin America and eastern Europe—regions that are home to the best performing bond markets in the world this year—acted more quickly to raise rates in response to the inflationary pressures that emerged when pandemic restrictions were eased and their economies reopened.

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