Inflation Shock Will Hit Bonds Hardest in India, Russia, Mexico

If the recent spike up in U.S. inflation numbers is a sign of things to come for global markets, that could prove especially bad news for investors in Indian, Russian and Mexican bonds.

The fixed-income securities of the three countries appear the most vulnerable to any surge in consumer prices, according to a Bloomberg study of 10 emerging markets. Their real bond yields — those adjusted for inflation — are the lowest in the group versus their three-year average. This gives them the smallest margin to spare if the nascent inflation signs prove the harbinger of a global price shock, making the bonds less attractive as yields adjust higher.

On the flip-side, the bonds of South Africa and Indonesia appear best positioned to weather any upsurge in inflation caused by the record central bank stimulus being rolled out to counter the coronavirus outbreak, the analysis found.

The quickening of inflation can be particularly destructive for emerging markets as it pulls down the real yield premium that compensates investors for holding riskier assets. Increasing price pressures also hinder the ability of central banks to cut interest rates, which may further complicate the process of recovery from the coronavirus pandemic.

“Should central banks be forced to have a less dovish stance and turn more neutral, this would cause a sell-off in the short and belly of the curve,” said Jean-Charles Sambor, London-based head of emerging markets fixed income at BNP Paribas Asset Management, referring to short- and medium-term government bonds. “The rally is behind us in our opinion.”

Over the Limit

One country already confronted with rising inflation is India, where the consumer price index has exceeded the central bank’s tolerance limit of 6% in every month this year except March amid a slew of interest-rate cuts. That has pushed down 10-year real yields to minus 0.68%, almost two standard deviations below the three-year average.

While the bulk of the upside surprise in Indian inflation has been due to rising food prices, there are less price pressures elsewhere in the economy due to local lockdowns to contain the virus.

An inflation challenge is also arising in Russia, where annual CPI climbed to an eight-month high of 3.4% in July, sending 10-year real yields down to 2.78%. In Mexico, a surge in fuel and energy prices saw headline inflation rise to a one-year high of 3.62% in July, posing a dilemma for policy makers about whether or not to cut rates further.

Broader Picture

The broader picture for emerging markets is much less clear. A gauge of consumer prices for developing nations as a whole dropped to 3.01% for the three months through June, compared with a 10-year average of 4.75%.

“Reflationary price pressures have historically spilled from developed into emerging markets, and appear to be trending higher,” said Damian Sassower, chief emerging markets credit strategist at Bloomberg Intelligence in New York. “Policy expectations call for EM central banks to begin tightening interest rates next year, as latent inflationary pressures boil over.”

Emerging-market inflation-linked bonds, which factor in expectations for consumer prices, are also showing a mixed picture. The yield on South Africa’s 10-year linkers has climbed to a six-week high of 5.14%, but is still below the average of 6.19% for the past decade. Brazil’s 10-year break-even rate rose to 4.21% last week from this year’s low of 3.47%.

While the picture is far from uniform, the general trend for inflation seems to be an upward one.

“Investors around the world are asking, to the extent there’s an enormous amount of stimulus, at what point does that become inflationary?” said Angus Bell, a senior money manager in London at Goldman Sachs Asset Management, which oversees $1.8 trillion. “We are watching inflation very closely.”

Country 10-Year Yield Latest CPI 10-Year Real Yield Z Score
India 6.25 6.93 -0.68 -1.92
Russia 6.18 3.40 2.78 -1.00
Mexico 5.89 3.62 2.27 -0.70
Brazil 7.69 2.31 5.38 -0.31
China 3.12 2.70 0.42 -0.30
Malaysia 2.65 -1.30 3.95 0.67
Thailand 1.40 -0.98 2.38 0.75
Turkey 13.83 11.76 2.07 0.76
Indonesia 6.98 1.54 5.44 1.13
South Africa 9.49 2.20 7.29 2.48

Methodology

  • The study looks at 10 major emerging markets. 10-year yield is based on Bloomberg valuation prices for local-denominated senior unsecured fixed-rate bonds issued by the sovereign
  • Real yield is calculated by taking benchmark 10-year yield and subtracting the most recent annual CPI reading
  • Z scores are calculated by subtracting the three-year average of the real yield from the current real yield, and dividing that by the three-year real-yield standard deviation

NOTE: Marcus Wong is an emerging-market strategist at Bloomberg News. The observations he makes are his own and not intended as investment advice.

— With assistance by Aine Quinn

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