The strong dollar and escalating US trade wars are forcing a reevaluation of emerging market (EM) local debt, a once-promising asset class for 2025. A hawkish Federal Reserve, coupled with resurgent inflation risks in countries like Chile, Sri Lanka, and Hungary, has dampened investor enthusiasm.
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Fed Stance and Trade Tensions Fuel Uncertainty
Following the Federal Reserve’s decision to pause interest rate cuts, Chairman Jerome Powell’s statement that officials are not “in a hurry” to lower rates has fueled investor skepticism about an imminent turning point. This uncertainty is compounded by President Trump’s trade policies. The imposition of tariffs on imports from Canada and Mexico triggered retaliatory measures, while China vowed “corresponding countermeasures” to levies on its goods. The resulting dollar strength adds further pressure on EM currencies.
Investors Retreat from Local Currency Bonds
Even before the recent escalation in trade tensions, some fund managers, including Loomis Sayles, were reducing exposure to local-currency bonds in developing nations. These bonds initially outperformed their dollar-denominated counterparts at the start of 2025, but the shifting landscape has led to a preference for hard-currency EM debt. Year-to-date, investors have withdrawn nearly a billion dollars from local currency bond funds, highlighting the growing caution. Furthermore, short sellers are increasing their bets against local-currency sovereign bonds in emerging markets.
Yield Differential Favors Hard Currency Debt
The yield advantage of local-currency bonds in developing economies has eroded, facing stiff competition from US Treasuries and hard-currency debt. Data reveals that the average yield for local-currency emerging sovereign bonds has trailed that of US Treasuries for eight consecutive weeks. This dynamic further reinforces the appeal of hard-currency bonds. “There is a concrete case favoring hard over local currency bonds on a risk-adjusted basis,” asserts Peter Yanulis, co-manager of Loomis Sayles’ EM debt blended total return strategy.
Central Banks Remain Cautious
The uncertainty surrounding US interest rates and trade policy also constrains central bankers in emerging markets. While most developing currencies have appreciated since President Trump took office, they remain vulnerable to external pressures. Samy Muaddi, head of emerging markets fixed income at T. Rowe Price, suggests that these currencies will act as the “relief valve” for any potential shocks. The recent unexpected pause in rate cuts by Colombia’s central bank, citing fiscal deficit concerns, inflation, and US tariff threats, underscores this cautious approach.
Searching for Opportunities Amid Volatility
JPMorgan Chase & Co. maintains an underweight position in EM local bonds, noting that rates haven’t adequately compensated for the increased risk. However, Claudia Calich, head of EM debt at M&G Investment Management, suggests that undervalued currencies in Latin America offer potential for outperformance for investors with a higher risk tolerance. Dan Shaykevich, co-head of emerging market and sovereign debt at Vanguard, has increased exposure to currencies in Latin America, Central Europe, and Africa, while remaining cautious on Asian currencies.
Conclusion: Awaiting Clarity
The outlook for EM local debt hinges on the evolving trade landscape and the Federal Reserve’s monetary policy trajectory. “When the EM tide finally turns, there is plenty of room for outperformance in a weak dollar environment,” observes Yanulis. For now, however, the future of this asset class remains uncertain. The “ball is in Trump’s court,” as Yanulis aptly concludes. Future rate decisions in countries like Mexico, India, and Poland, along with inflation data from various emerging markets, will provide crucial insights into the evolving dynamics of this market.
