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EM/LATAM Strategy Summary

Core Content

This document outlines the EM/LATAM Strategy from Banco BNP Paribas Brasil S.A., focusing on the long of the US curve in real terms and credit cheapness as key factors influencing financial flows and currency movements in emerging markets (EM) and Latin America.

The strategy is based on the analysis of forward-looking US real interest rates and their long-term impact on EM and Latin American financial assets. The central idea is that real rates are the most significant determinant of currency moves and financial flows in the medium to long term, rather than nominal rates. This is because investors can adjust for inflation, leading to a focus on real rate differentials.

Main Views

• Real Rates Matter Most: Exchange rates and financial flows in EM and Latin America are primarily driven by real interest rate differentials, not nominal ones.
• US Real Rates as a Key Driver: The US real interest rates influence the lending of US dollars outside the US, which is a fundamental external factor for EM and Latin America.
• Central Banks' Limited Influence: Most EM/Latin American central banks have limited ability to influence long-term interest rates in their own currencies, and changes in their policy rates have a relatively small direct impact on the US curve.
• VAR Model Analysis: A bivariate VAR model was used to simulate the response of EM and Latin American yields to changes in US real interest rates. The results show that a permanent 45bp increase in US real rates would lead to a 83bp increase in Latin American blended yields after one year.
• No Structural Reversal Expected: As long as the US curve does not steepen rapidly and Fed hikes are orderly and anticipated, financial flows are unlikely to reverse structurally.
• Credit Risk Vulnerability: EM credit risk is vulnerable to a sudden repricing of the long end of the US curve.
• Monitoring US Real Rates: Although the asset class is not considered expensive, the strategy includes monitoring US real rates with caution and adjusting strategies if a sudden trend change occurs.

Key Information

• The analysis is a follow-up to an earlier report (EM flows model) published on 11 June.
• Charts 1-6 illustrate the relationship between US real rates and Latin American spreads over US rates.
• Charts 9-14 show the hypothetical response and trajectory of EMBIG and EMBI Latam to US real interest rate shocks.
• The strategy is based on the assumption that long-term rates are more relevant than short-term rates in assessing the impact on EM markets.
• The BIS and IMF recommend focusing on long-term rates for current conditions.
• Legal and Risk Disclaimers are included, highlighting the non-independent nature of the research and potential conflicts of interest.
• The document includes important disclosures regarding options, ETFs, and convertible securities, emphasizing the complexity and risks associated with these instruments.
• The document is intended for professional clients and is not investment research under MiFID II.

Caveats and Risks

• The current combination of rising energy prices, less accommodative Fed, and balance sheet reduction could be toxic for risk assets.
• A sudden change in US real rates could lead to significant adjustments in EM and Latin American yields.
• Trade wars and structural breaks are potential risks that could impact EM and risk assets, though historical data is not available to assess this.
• The results are hypothetical and based on simulations, not actual performance.
• The document is for informational purposes only and does not constitute an offer to sell or issue securities.

Conclusion

The strategy emphasizes the importance of US real interest rates in shaping EM and Latin American financial flows and currency movements. While the current environment suggests no structural reversal, the strategy includes caution and monitoring of US real rates and potential trend changes. The analysis is non-independent, and the legal and risk disclaimers should be carefully considered.