Emerging Market Fixed Income Monthly Outlook – May 2016

12 May 2016

Will Russia cut interest rates?

Incredibly, the Russian central bank has become one of the country’s strongest institutions – not only domestically but comparatively strong amongst of the emerging market (EM) central banks.

President Putin and other government leaders have respected central bank decisions and refrained from any public exertion of pressure over the past three years, even during the height of geopolitical crisis. Governor Elvira Nabiullina managed to raise interest rates aggressively in 2014, allowing a large depreciation in the Russian ruble (RUB), and refrained from reversing course until inflation has subsided – all textbook responses to a terms of trade shock that have nevertheless proven exceedingly difficult for other countries’ central banks to undertake.

This episode now creates an opportunity for impressive interest rate cuts, owing to three factors: most intuitively, conservative monetary policy with a bias to anti-inflation decisions allows for the central bank to undertake a full cycle of easing without risking a relapse of inflation risk or vulnerability. Second, inflation expectations are likely to remain anchored, built on a pattern of stability and prudence, reducing inflation risk premium along the curve. Last, enhanced central bank credibility under Nabiullina helps compress term premium and can allow for a lower neutral real interest rate level over the longer run. Having taken advantage of the crisis to demonstrate orthodoxy and independence, the central bank in theory may even be able to guide real interest rates to an even lower level than before.

How can investors benefit from these changes? Local currency bond duration is one of the few unique alpha sources in EMs. Unique, we say, because it is uncorrelated to general risk factors that typically drive emerging market assets like currencies and credit. Also what one central bank does has nothing to do with another — or any other — central bank, even in a neighboring country. Each country can exhibit its own local monetary dynamics and idiosyncratic set of domestic risks which, in theory, each central bank responds to according to its individual mandate and reaction function.

Russia’s ability to ease interest rate policy may sound counterintuitive at a time when EM credit risks are heightened, currencies have devalued sharply, and other countries – from Colombia to South Africa – are raising interest rates. Even specific to Russia, credit spreads have widened from 140 to 220 basis points and the RUB stands over 50% weaker compared to the eve of the taper tantrum that occurred in May 2013 (see chart below). Here, unique alpha plays out clearly: with Russian GDP (Gross Domestic Product) growth running -3.8% on a rolling year-over-year basis and inflation having declined to 7.3% on an annualised basis from 12.9% last year, conditions clearly permit a reduction in policy rates from 11% currently. Assuming inflation remains in a stable range, real interest rates now measure nearly 4% and could be reduced by as much as 400 basis points simply to match levels prior to the currency devaluation.

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