Wary investors spy trouble in Brazil and India bonds

Few people would put the emerging market powerhouses of Brazil and India in the same economic bracket as the stricken peripheral eurozone nations. Yet a closely watched market indicator is signalling a worrying parallel.

It is accepted wisdom in developed markets, particularly in the US, that a prolonged inversion of the yield curve is a sign of trouble to come.

When interest rates on short-term bonds move higher than those on longer-term bonds – so the theory goes – the economy is in for a sharp slowdown or even a recession.

It should come as no shock then that the countries with the most severely inverted yield curves are the European debt crisis economies of Greece, Ireland and Portugal.

What might be more surprising, however, is that next in line are the emerging market favourites of Brazil and India.

In recent weeks, the yield curves in both these countries have inverted as central banks increase rates to try to compensate for rising inflation, causing some investors to predict that a downturn is on the way for the leading emerging markets.

“We have less than 2 per cent of our mutual fund invested in emerging market stocks and have no emerging market debt in our asset allocation accounts,” said Richard Bernstein, former chief investment strategist for Merrill Lynch, who now runs his own firm, Richard Bernstein Advisors.

Emerging markets have been engaged in an increasingly aggressive battle with inflation.

Brazil’s central bank has increased rates five times this year from 10.75 per cent to 12.25 per cent.

This has maintained Brazil’s position as the economy with the highest real interest rates in the world.

The consumer prices index at the end of May was up 6.55 per cent compared with a year earlier – above the central bank’s target of 4.5 per cent plus or minus 2 per cent. This is taking its toll on economic growth, which the government predicts will soften to about 4 per cent this year compared with 7.5 per cent in 2010.

The Reserve Bank of India has raised rates nine times in just over a year. With inflation data for May higher than some estimates at just over 9 per cent, economists are expecting the RBI to raise rates 25 basis points this Thursday and maintain its hawkish tone.

India’s sharp monetary tightening to combat high fuel and food prices is affecting overall economic growth and curbing discretionary spending on goods such as cars.

But, for the time being, the RBI appears to be “focused on combating inflation even at the cost of sacrificing near-term growth”, says Kumar Rachapudi, vice-president and fixed income strategist at Barclays Capital in Singapore.

Mr Bernstein says the challenge for the so-called Brics club of large emerging markets is to bring M2, a measure of monetary supply, back under control. This has been growing at 15-30 per cent in these countries compared with 5 per cent in the US.

“Governments in Brazil, India and China are caught between a rock and a hard place,” says Mr Bernstein, noting that if they continue to tighten, they could slow economic growth to a point that is politically unacceptable, but if they do not act, basic items such as food could become unaffordable.

“Our research suggests that valuations in these markets are too expensive given that rock-and-a-hard-place potential choice that lies ahead,” he says.

Other analysts argue that the inverted yield curve in Brazil and India is more of a statement about the near-term direction of interest rates rather than a prediction of economic gloom.

In Brazil, real interest rates are high because of the country’s history of runaway inflation.

But the longer term trend is for real interest rates to fall as successive governments demonstrate a commitment to lower inflation – as reflected in lower interest rates on longer-term bonds.

“Most people expect the trend for nominal rates in Brazil to be declining,” says Bret Rosen, senior credit strategist for Latin America at Standard Chartered.

This can lead to yield inversion, however, during central bank tightening cycles as interest rates on short-term bonds temporarily rise above those of longer-term securities.

This is more of a short-term technical effect than a reliable indicator of recession, analysts say.

“The shape of the curve is more a statement on what the markets believe Copom [the monetary policy committee of the central bank] will do about rates and inflation,” says Paulo Leme, director of emerging markets research at Goldman Sachs.

But while they may not be predicting a downturn, the inverted yield curves in Brazil and India, this time around at least, are a sign that the breakneck economic growth of the past few years may be slowing.

Mr Rachapudi says a look at the one-year rate implies that investors think policy tightening will stop or at least ease once inflationary pressures abate.

But he says that, in reality, the two-year versus five-year spread gives a better indication of where the market sees the Indian economy. That, Mr Rachapudi says, “shows that the market believes the current hikes will lead to lower future inflation and possibly lower growth”.