By Sujata Rao
LONDON, July 9 (Reuters) - Emerging markets are calling time
on their year-long rate-cutting cycle, fuelling a selloff in
short-maturity bonds, and some investors are betting the easing
has gone far enough to merit inflation hedges for the future.
With rates bottoming out and expected to start rising next
year -- much earlier than expected in developed markets --
investors are betting on flatter emerging market yield curves by
dumping the front-end, buying bonds that hedge their inflation
risk and looking at currencies that could gain as rate cuts end.
Inflation has historically been a sticky issue in emerging
markets and is possibly at the back of central bankers' minds as
they increasingly signal -- despite still-anaemic growth -- that
they are done cutting rates or are very near the trough.
The easing cycle that began last autumn has seen central
banks from Mexico to Korea take the axe to interest rates,
slashing hundreds of basis points from policy rates and bringing
rates in many countries to historic single digit lows.
To be sure, there are exceptions. Russia, Mexico, Peru,
Chile, Kazakhstan and even Turkey will likely cut rates again.
But with economies predicted to recover sooner than in developed
markets and given emerging markets' greater vulnerability to
food and energy prices, it may all suggest in hindsight that the
easing cycle went too far.
"Through the cycle, one thing that worried me is emerging
central banks may have over-estimated how much they might need
to ease but now they are becoming more sensible," says Kieran
Curtis who runs $300 million in emerging bonds at Aviva. "Last
month, many central banks did not cut and that's very telling."
"Chile's yield curve for instance is incredibly steep even
though it's a high-quality credit with no fiscal sustainability
worries -- this reflects very loose current monetary policy than
any worries about future growth."
POSITIONING FOR THE CHANGE
Investors have started to position for the end of the cycle.
While the rate cuts drew buyers to the front end of the bond
curve -- bonds with short maturities -- investors have started
to bet yield curves will flatten as short-term rates rise and
the gap between short and long yields becomes less marked.
Yield curves in countries like Chile and Israel that cut
interest rates the most, are up to 300 basis points steep.
"EM inflation and inflation expectations are likely to
bottom out over the next few months...We think the best way to
protect lower rates will be to tighten monetary policy
cautiously but at an early stage," TD Securities told clients.
"We believe the time has come to consider flatteners in
major EM countries as early rate hikes would push the short end
higher while the longer end would benefit from early action."
Many like Curtis believe the drastic rate cuts coupled with
ongoing fiscal easing make inflation-linked bonds, or linkers, a
good hedge in some countries. He has bought linkers in Poland
and Turkey and has a short-term flattener trade in Turkey.
Linkers are instruments whose principal and coupon payments
are linked to inflation to reduce investors' inflation risk.
Werner Gey van Pittius, strategist at Investec's $240
million emerging bond fund likes a flattening trade in Chile and
expects emerging currencies to appreciate as rate cuts end.
"We like the curve flattening trade," he said. "Yield curves
have become extremely steep, you have to make a call on how much
flattening is priced in... we are cutting duration and skewing
the portfolio towards flatteners, FX and linkers and we will add
more beta on the FX side as summer progresses," he said.
Julien Renoncourt deputy head of fixed income at Sinopia, an
HSBC fund that manages 1.3 billion euros in emerging linkers
also picks Poland and Turkey as credits offering a discount in
terms of the inflation expectations that markets are pricing in.
TIMING
Not all see inflation hedges as necessary.
Weak growth data and fresh concern over the global economy
have prompted some to re-evaluate the view that the emerging
tightening cycle is imminent, pushing bond yields broadly lower.
For instance, Korea's central bank dampened rate rise
expectations on Thursday, citing subdued inflation and growth.
Bhanu Baweja, head of emerging fixed income and FX strategy
at UBS, says the market is pricing rate hikes too soon as broad
money supply is not growing fast enough to make inflation a
threat in the near term for emerging markets outside of Asia.
"I can't understand why people are getting excited about
central banks having to hike rates in the short term to the
extent which is getting priced in," Baweja said. "In fact the
clear reality in large parts of EM is one of disinflation."
He recommends receiving short-end rates in countries where
they have been sold off due to rate rise expectations.
And unless another bout of global risk aversion kicks in,
the end of easing should prop up currencies, a key
inflation-limiting measure in emerging nations. Despite the
swingeing rate cuts, emerging currencies still offer a
substantial premium to the near-zero rates in developed nations.
Most agree Asia, which is seen leading the global recovery,
will be the first focus of policy tightening.
In India for instance, stronger-than-expected growth and
price pressures suggest policy may be tightened by end-2009.
Aviva's Curtis also noted that while year-on-year inflation
in most countries remains weak, monthly numbers are ticking up.
"The consensus is that rates will be held low for a while,
but once big central banks like India start thinking of raising
rates, which will happen in the next few months, others must
start thinking of it as well," he said.
(For a graphic on main emerging market interest rates please
click on http://graphics.thomsonreuters.com/079/UK_CBRTS0709.jpg
For a graphic on 2009 rate cuts in emerging markets, click
on http://graphics.thomsonreuters.com/079/UK_CBRTCT0709.jpg)
(Reporting by Sujata Rao; Editing by Toby Chopra)
