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Inflation Stalks Emerging Bonds, Stoking Demand for Refuge

(Bloomberg) — As the global economy rebounds and commodity prices hit multi-year highs, emerging-market investors are seeking refuge in the one area that offers protection from inflation concerns.While this year’s global bond rout and the prospect of accelerating inflation have inflicted pain across markets from Brazil to Russia, debt securities that are linked to the pace of consumer-price gains have weathered the storm better than their nominal counterparts.Surging price pressures have long been a scourge eroding the appeal of developing-market bonds and currencies. Now, data across the world is flashing warning signs again. U.S. inflation for March came in higher than estimates, while CPI also picked up in Peru, Brazil, South Korea and India due to a surge in energy and food costs. On Thursday, inflation in Mexico rose to the fastest pace in over three years. Meanwhile, central banks face pressure to keep rates low to contain the economic fallout from the coronavirus pandemic.“The quickest way for EM policy makers to stimulate the economy is via monetary policy,” said Michael Roche, a strategist at Seaport Global Holdings in New York. “This activity builds inflation expectations, which leads fixed-income investors to seek protection in CPI-linked securities.”Inflation expectations are likely to keep climbing as emerging-market central banks take the lead from the Federal Reserve, Roche said. The Fed has signaled that it will continue with expansionary monetary policy for an extended period. Five-year Treasury breakevens — a bond-based measure of inflation expectations in the world’s biggest debt market — have climbed to nearly 2.6%, hovering close to the highest in over a decade.Pace SetterAmong emerging markets, South Africa leads the charge, with five-year breakeven rates to 4.4% on expectations the central bank will fail to contain prices amid rising energy costs. While concern is high, inflation quickened less than forecast in March as underlying pressures remain muted for now. South Africa’s 2033 inflation-linked bonds have gained 6.1% so far this year, handily surpassing the 1.9% loss in equivalent-maturity, nominal bonds.Inflation expectations in Brazil are almost as high, with one-year breakeven rates climbing to 5.1%, the upper bound of the central bank’s target range for 2022, amid increased government spending. As a result, Brazilian inflation-linked bonds maturing in 2030 have weakened just 6.8%, even as their fixed-rate counterparts cratered 9.6%.In Turkey, rising oil prices and a weak currency are set to fuel a surge in consumer costs, even as President Recep Tayyip Erdogan — who fired the last central bank chief — pushes for interest rate cuts. Inflation accelerated to 16.2% in March from 14.6% at the start of the year. Turkish inflation-linked bonds maturing in 2028 have lost 2.1% this year, while the nominal benchmark bonds plunged nearly 21%.In Asia, South Korea’s inflation-adjusted bond yield curve flattened across all tenors, as demand picked up to take into account the potential return of higher consumer prices. Inflation in the North Asian nation returned to its pre-pandemic level in March amid higher oil prices and as consumer demand started to recover.Philippine bonds lost 4.2% this year in nominal terms as inflation breached 4%, the upper end of the central bank’s target, for three straight months on the back of higher food prices.The RisksThere are risks to the strategy. Edwin Gutierrez, a portfolio manager at Aberdeen Asset Management in London, says that while the trade may hold up for another month or so, food and fuel prices seem to have peaked.“You switch out of fixed-rate paper into linkers and you lock in some big losses,” Guttierez said. “It’s a bit late for the trade.”Gennadiy Goldberg, a rates strategist at TD Securities in New York, also stresses the need to be watchful.If inflation doesn’t materialize, “we could see some investors taking profit on their inflation hedge and that could lead the move to reverse” later this year, he said.For the moment though, with inflation fears on the rise across the world, investors may still look for a hedge.“We’ll continue to see some strength in the near-term” in inflation-linked bonds, Goldberg said. “Markets are betting loose central bank policy, pent-up demand, and accelerating growth expectations will create a perfect storm for inflation.”(Updates to include Mexican inflation figures in third paragraph.)For more articles like this, please visit us at bloomberg.comSubscribe now to stay ahead with the most trusted business news source.©2021 Bloomberg L.P.

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