BofA says markets misprice EM monetary cycles

Investing.com -- Bank of America said markets continue to misprice emerging market monetary cycles, recommending investors pay rates when central banks hike and receive when they cut.

The bank tested a trading rule across multiple emerging market countries, finding that paying the front-end during rate hike cycles and receiving during cuts has worked in most cases. The strategy failed in only a handful of cycles, according to the research.

In some instances, such as the recent Czech easing cycle, receivers performed better for 1-year swaps than for 2-year or 1-year-1-year forwards, as the terminal rate was anchored by the central bank.

Bank of America's analysis showed that a simple rule using 1-year trades typically outperforms alternatives across most countries. The rule involves paying or receiving the 1-year swap after it crosses the interbank rate, then switching the position only when the swap crosses the interbank rate again from the opposite direction. The analysis assumes zero transaction costs.

The bank identified three factors behind market mispricing. Monetary cycles tend to be long, reducing forecasting accuracy over extended periods. Markets also require a risk premium that increases over time to account for potential errors. Carry and roll become more negative when markets continue pricing in rate changes before central banks act.

Post-COVID performance showed significant improvement across most emerging Europe, Middle East, Africa, Asia and Latin America countries. The hiking cycles in 2021 proved particularly profitable in the backtest, as unexpected inflation increases boosted returns.

Latin America produced the best backtested results, particularly in Brazil using the simple rule. Asia showed the weakest performance, especially for 1-year-1-year trades in Taiwan. EEMEA fell between the two regions. Bank of America attributed the regional differences to more open capital accounts in EEMEA and Latin America, which create deeper and longer rate cycles.

The bank's rules currently indicate a bias toward paying rates in most emerging markets, with exceptions for Hungary and Israel. Some rules also suggest no action in Poland, India, Singapore, Brazil and Chile.

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