Emerging markets diverge as rate-hike cycle tails off

LONDON: Growing uncertainty over thecourse of interest-rates is sharpening the divergence within emerging markets,displacing early year fears the sector was set for a long inflationbattle.

Faltering global demand is prompting some central banks tothrow monetary policy into sharp reverse and the dovish tilt has spurred arotation of investment back into emerging assets.

Central banks fromChina to Chile were almost in lock-step over the last 12 months, raisinginterest rates to combat the inflationary pressures that bedeviled thedeveloping world.

But with questions about the global economicexpansion compounded by the deepening euro zone crisis, monetary policymakersare having a rethink. Some are now openly flagging the end of their rate risecycles, leaving investors to parse policy statements for clues on whether theinflation fight at large may already be over.

"Inflation was the bigstory in the early part of this year but now there is a big question mark aboutglobal growth and downward pressure on emerging-market interest rates," saidBenoit Anne, emerging markets strategist at Societe Generale.

"On theback of the initial inflation concerns, yield curves were pricing in too manyrate hikes in the pipeline."

The Organisation for EconomicCo-operation and Development (OECD) said this week that leading indicatorsshowed that the world's leading economies headed for aslowdown.

Recent U.S. jobs data has come in below forecast, fuellingfears that the world's biggest economy has entered a soft patch while growth inChina, whose voracious appetite for raw materials chased commodity prices torecent highs, is slowing.

Though food prices -- a key source of pricepressures in developing markets -- remain elevated enough to pose an upside riskto inflation, scaled back expectations for global growth have pulled oil prices off their May peaks.

Easing commodityprices and the supportive year-on-year base effect are leading to more mutedinflation readings, giving investors enough cause to think central banks areeither slowing down monetary tightening or ending rate hikes for themoment.

"It's not to say we're out of the woods (in terms ofinflation) but a lot of the fears have been priced in," said Edwin Gutierrez,debt portfolio manager at Aberdeen Asset Management.

"At the start ofthe year, pretty much every long end of the (yield) curve was sold off. Now it'smuch more of mixed bag, varying according to country."

END OF CYCLE?

Central banks are expected to stay slightly more hawkish in Asia,where growing domestic demand, surging property prices and tight labour marketshave conspired to sustain inflationary pressures.

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Thailand onWednesday upped its benchmark rate, warning of more to come, while India lastmonth raised its rates for the 10th time in just over a year, signalling more inthe pipeline.

Though last week's rate hike was seen by some as thepenultimate one in People's Bank of China's current tightening cycle, manyanalysts now argue that lending rates may have to be raised further with annualinflation in June hitting its highest in three years.

In LatinAmerica, expectations are rising that some central banks will soon hold fire onmonetary tightening.

The Mexican central bank last week kept itsbenchmark rate unchanged and Chile is also seen doing so thisThursday.

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Brazil, still seen ratcheting up lending rates, this weeksignalled it was comfortable with its 2011 inflation forecast despite a recenthigher-than-consensus reading.

Fellow emerging giant Russia held itskey policy rates last month and is poised to reverse its monetary tighteningpolicy after a central banker said the economy could even experience somedeflation in the coming months.

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Meanwhile, the euro zone's persistentfiscal woes could prompt a pull back in Western European bank lending in easternEurope that could reduce the need to tighten policy there.

The globalshift towards a more neutral monetary policy is encouraging for emerging marketsas a whole, said Citi strategist Luis Costa.

"If you're a fundmanager you'd want to be at the end of the (rate hike) cycle as the deceleratingpace of interest rates hikes enables the stabilisaton of the yield curve," Costaadded.

Strong fixed income inflows, particularly in local-currencybonds, have buoyed currencies such as the Polish zloty and South Africa's randin recent weeks.

According to JPMorgan, bond investors poured some$30 billion into the main local debt markets of emerging Europe, Middle East andAfrica in the first six months of this year, up from $25.6 billion a yearago.

But as the rate hike cycle in emerging economies tails off, thevulnerabilities of some economies come into sharper focus.

Investorsare increasingly taking a bearish view on Turkey, which has been reluctant toraise rates even with an overheating economy, warning that the country'swidening current account deficit leaves it exposed to externalshocks.

If the crisis in the euro zone spills over to European Unionmembers Poland, Romania and Hungary, they could find themselves raising rates tostabilise their currency exchange rates.

"The push to raise ratescould come not from inflationary pressures but from the need to shore up thecurrency," said David Hauner, Head of EEMEA economics and fixed income strategyat Bank of America-Merrill Lynch Global Research.

"There will begreater differentiation among investors between the strong and weak emergingmarkets."