What is the Outlook for Asian Local Currency Bonds as the Fed Battles Inflation?

As the Fed continues to fight rising prices, we explore how this affects Asian local-currency bonds and what opportunities exist for investors in a challenging global economic environment.

The US Federal Reserve (Fed) remains focused and resolute in its commitment to tame inflation and, just as importantly, inflationary expectations. And the central bank’s primary tool to combat rising prices has been a series of hawkish interest rate rises. However, these increases also have the potential to act as a brake on economic activity. As such, the real challenge for the Fed is performing a balancing act between slowing the economy enough to control inflation without causing it to stall and crash.

A Hawkish Fed Could Still Slow the Pace of Interest Rate Increases

The Fed’s inflationary target is set at 2%¹, and officials have made it clear they are prepared to continue with their rate-hiking path to achieve this goal. Recent consumer price index data showed that the headline number had eased from an annual rate of 8.2% in September to 7.7% in October² . This weaker-than-expected increase was the lowest monthly rise since January 2022. The favorable implication stemming from this outcome is that the Fed may no longer be required to follow such an aggressive pace with its interest-rate increases. 

The Fed’s Actions Affect Most Markets – But Not All

Most central banks worldwide have felt compelled to follow the Fed’s lead and elevate the cost of borrowing. Not only to combat inflation but also to prevent their currencies from being devalued. If a central bank lets its currency weaken excessively, then it risks importing inflation as the price of foreign goods and services increases. At that point, they’d need to hike interest rates anyway to control inflation. A major exception to this rule is China. Owing to its scale, economic power, and the fact China is at a different stage in its economic cycle compared to Western economies, it has been able to chart a different course.

China Poised for Post-Pandemic Recovery

There are positive signs that China is beginning to relax its strict zero-COVID policy³ . While a full reopening is not likely in the near term, the longer-term picture suggests that the economy will benefit when free movement and activity resume. An explosion of pent-up demand will likely be injected into the economy as consumers spend on goods and services foregone during the height of the pandemic. China’s government can also use its ability to prime the economy through fiscal and monetary policies – this is not an option many economies possess. Another positive development is that after the National Congress of the Chinese Communist Party, Premier Xi Jinping consolidated his leadership, which permitted a continuation of his long-term policy goals⁴ . These prioritize quality economic growth, innovation and investment in key technological areas and a reduction in income inequality.

What Does This Backdrop Mean for Asian Local Currency Bonds?

Any indications that central banks will no longer need to increase interest rates by as much or as quickly should be considered favorable for bond investors. Fortunately, most central banks in Asia have been ahead of the curve in countering inflation. Such vigilance means that interest rates could stop increasing if price rises stabilize. This would boost local-currency bonds from both a yield and a carry perspective as their attractiveness to investors increases.

How Should Investors Position Themselves?

Steep declines in several Asian currencies earlier this year could mean that a worst-case scenario in terms of the future pathway of US interest rates is already priced into local bonds. Asian central banks have been using existing reserves to let their currencies decline smoothly, which has avoided destabilizing precipitous drops⁵ .

This would provide an additional opportunity for investors to capture attractive yields and potential gains. That said, companies that have issued a large amount of debt in US dollars rather than their local currency should be viewed cautiously, as they may struggle to repay their debts if the US dollar continues to strengthen.

In the medium term, shorter-duration bonds may provide some protection if US interest rates continue to rise on their predicted path. However, when interest rates in the US look close to peaking, shifting to longer-duration bonds could be potentially advantageous. In terms of sectors, investors could seek the issuance of businesses exposed to consumer demand in China as well as those in technologically advanced areas, which China is now prioritizing.