The Threat of American Exceptionalism Rises, Emerging Market Local Currency Bonds Welcome a "Shining Moment"

According to the Zhitong Finance APP, although the yields on local currency bonds in emerging markets are even lower than those of U.S. Treasuries, they are still expected to outperform their dollar-denominated counterparts. The turmoil in global trade has raised expectations for interest rate cuts in developing countries, while falling oil prices have suppressed inflation, leading to better performance of these bonds compared to dollar bonds since the beginning of this year, marking the best start since 2022. Meanwhile, the dollar has weakened under the threat of tariffs from U.S. President Donald Trump, resulting in poor performance of dollar bonds.

Jon Harrison, Managing Director of Emerging Markets Macro Strategy at GlobalData TS Lombard in London, stated, "Given the weakness of the dollar and the greater room for emerging market central banks to lower policy rates, we strongly prefer local currency bonds in emerging markets over dollar-denominated bonds."

He also pointed out, "The slowdown in the U.S. economy and the increasing likelihood of recession are detrimental to global growth and are likely to further prompt emerging market central banks to cut interest rates."

Bloomberg's index shows that the return on local currency bonds in emerging markets has reached 3.2% this year, while dollar-denominated counterparts have only risen by 0.7%.

The outstanding performance of local currency bonds has led to an unusual situation: historically riskier bonds are trading at yields lower than those of dollar-denominated bonds, which have traditionally been a major safe-haven asset globally. The average yield of the local currency index has dropped to 4.03%, compared to 7.1% for the dollar-denominated bond index and 4.12% for U.S. Treasuries.

In recent weeks, one of the main drivers of local currency bonds has been the market's increasing expectation that central banks will ease monetary policy due to the market turmoil triggered by Trump's announcement of "reciprocal tariffs" on April 2.

Data compiled by Bloomberg shows that in April, the one-year interest rate swap index composed of 18 emerging economies fell by about 15 basis points in that month alone, expected to record the largest monthly decline since September.

"Increased Volatility"

Philip McNicholas, Asian Sovereign Strategist at Robeco in Singapore, stated, "In larger markets, we prefer local currency bonds because they provide us with more ways to express views on currency, monetary policy, duration, and yield curves."

He noted, "The increased volatility of U.S. Treasuries and U.S. policies should bring higher term premiums, and indeed it has, which weakens the appeal of the dollar." The term premium is the compensation that bond investors require for bearing the risk of interest rate fluctuations over the life of the security.

As the weakening dollar boosts the performance of emerging market currencies, local currency bonds in emerging markets may gain further momentum. The Bloomberg Dollar Spot Index has fallen nearly 4% in April, marking the fourth consecutive month of decline.

Mike Riedel, Fixed Income Portfolio Manager at Fidelity International in London, stated, "After a decade-long bull market for the dollar, it still looks very expensive. A correction of the dollar's overvaluation, combined with heavy long positions in the dollar, could be a major positive factor for emerging markets in the coming years."

Declining Issuance

The deteriorating outlook for the dollar has made some bond issuers more cautious about issuing dollar-denominated bonds Data compiled by Bloomberg shows that in April, the issuance of U.S. dollar bonds in emerging markets, excluding China, fell by 36% compared to the same period last year, totaling only $5.1 billion.

Institutions such as Goldman Sachs have stated that the performance of local currency bonds in emerging markets is expected to continue to outperform similar bonds.

Goldman Sachs analysts Andrew Tilton and Kamakshya Trivedi wrote in a research report released last Thursday: "In the face of recession concerns, we believe that local currency interest rates in emerging markets will outperform other emerging market assets."