EM Local Currency Bonds: Why Non-Dollar Assets Now?

The top reason given recent trends is higher growth. Higher growth typically supports currencies and attracts capital flows, which then increases asset prices. The US dollar’s strength over the past 13 years has reflected the relative strength of the US economy. Now, we see emerging economies rebounding after the COVID-19 pandemic, thanks in part to the reconfiguration of global supply chains, and the growth differential between emerging and developing countries increasing to around 3.5% from the current 3%.

In addition, local currency bonds have a history of outperforming other global fixed income sectors when the dollar has been weak. In 2003–2011, the JP Morgan Emerging Markets Bond Global Diversified Index returned around 12% annually, while the Bloomberg Global Aggregate was up around 6% per year. Similarly, since the dollar’s most recent peak in late 2022, the return on local currency emerging markets bonds was more than double the 10% return on global fixed income through the end of last year.

Many governments have shown impressive fiscal discipline over the past several years, and we do not currently see any major imbalances in emerging local bond markets. In sharp contrast with the periods of runaway inflation years ago, central banks in developing countries acted preemptively against rising prices in 2021 and 2022 with aggressive rate hikes. With the drop in inflation, many emerging markets central banks have reached the end of their rate-hike cycles and are in a position to cut rates—or have already started. When the Fed begins easing, they will likely have more leeway to reduce rates without putting too much pressure on their currencies against the dollar. Falling domestic rates, in turn, should create the opportunity for capital appreciation in local currency bonds.

Local currency bonds are priced at steep discounts to those in developed markets, in large part because foreign investment flows plunged last year. We expect the high return in local emerging bond markets over the past 12 months to attract inflows, as it has in the past, and begin driving valuations higher in 2024.