Dovishness catching up in Asia; rate cuts to create opportunities

Expectations regarding the outcome from the Federal Reserve (Fed) meeting later this month has been swinging between a 25 and a 50 basis point cut. This dovishness is inevitably spilling over to Emerging Market (EM) central banks.

Korea and Indonesia were among the first central banks in Asia to react ahead of the Fed meeting. Both central banks cut policy rates by 25 basis points¹, with Indonesia leaving the door open for more rate cuts. Korea’s rate cut was a surprise against expectations that the central bank would wait until September to ease. Both the Bank of Korea and Bank Indonesia noted weaker domestic growth, low inflation and a dovish Fed as reasons for easing monetary policy. Both banks also signalled the intention to keep their monetary policy stance accommodative going forward. Outside of Asia, South Africa reversed last November’s hike by cutting policy rates by 25 basis points² but kept its tone broadly neutral given concerns of rising inflation.

When the Fed hiked aggressively last year, causing the USD to appreciate against most currencies and the DXY to rally nearly 10%, EM central bankers were pushed to hike policy rates, particularly to contain currency depreciation. This year, while Eastspring Singapore’s Multi Asset Solutions (MAS) team believes that the Fed will cut rates more gradually than what the market expects, the dovish shift in Developed Market monetary policy is likely to allow EM central banks to cut rates in the coming months.

What are some of these markets? We plot the change in real GDP growth over the past 2 quarters against the inflation gap (difference between the inflation target and the average 6-month inflation rate) for selected EM economies in Fig. 1. Economies in the bottom left quadrant display macroeconomic conditions (real GDP growth decelerating, and inflation is running below target), that make it more likely for them to ease monetary policy.

Fig 1: Slowing growth and low inflation suggest that economies in the bottom left quadrant have room to ease monetary policy

We further plot the change in policy rate for each of these economies since early 2017, the rate cuts year to date and market expectations regarding the change in the policy rate over the next one year. Fig. 2 clearly shows how monetary policy has reversed in some markets, from rate hikes last year to rate cuts this year. It also shows that in certain Asian economies such as Indonesia and the Philippines, their central banks may need to cut rates more than what is currently priced in, in order to reverse the rate hikes in 2017/18.

Fig 2: Markets may not be pricing in enough rate cuts in the Philippines and Indonesia

The MAS team sees rate cuts in Philippines, Indonesia, Thailand, Malaysia and India over the coming months.

The Philippines had hiked aggressively last year amid rising inflation and a weaker currency. With headline inflation plummeting from nearly 7% year-over-year in end-2018 to under 3% more recently, the central bank has room to ease monetary policy further. In Thailand, while financial stability concerns (particularly over high household debt) may make the central bank hesitant to cut rates initially, weaker growth, low inflation and a stronger Thai Bhat will probably trigger a 25 basis point cut in late Q3/early Q4, in our view. Meanwhile, China is likely to keep rates low and liquidity conditions accommodative as it aims to stabilise economic growth amid weak trade.

As for India, lower policy rates are likely given weaker than expected growth, below target inflation and a contained fiscal deficit. The Reserve Bank of India will also probably ease liquidity, especially to the non-bank financial institutions and public sector banks.

We expect the Monetary Authority of Singapore to reduce the slope of the Singapore Dollar Nominal Effective Exchange Rate — the exchange rate between the Singapore dollar and a basket of currencies of the country's major trading partners - at its October meeting, to support growth after Singapore’s Q2 GDP fell to 0.1% yoy, the lowest since the Global Financial Crisis.

Outside of Asia, Brazil, Chile, Mexico and Russia are all likely to cut rates this year.

With the Fed and EM central banks poised to cut rates further and keep monetary conditions accommodative, the MAS team sees opportunities in markets where rate cuts are currently under-priced. We favour Indonesian local bonds, in particular.

We remain positive on US and Asian High Yield bonds, as well as on duration. We see rates drifting lower in China as liquidity remains easy.

Over in India, the team expects the liquidity impulse from the central bank to be more powerful than rate cuts, leading us to favour Indian equities over Indian bonds, a somewhat contrarian view given the prevailing negative sentiment towards the former.

We are also positive on the Russian ruble and Australian rates.