How to trade the risk of rising US rates in Latin America

Even if US interest rates do rise, they will do so as a result of better economic conditions so this will be beneficial for Latin America, analysts say

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Higher interest rates in the US are not the baseline scenario for economists at Bank of America Merrill Lynch. But “even if they do rise, that would be the result of better US growth prospects,” they wrote in a recent report.

“Inflows into emerging markets will remain high but with a different composition,” the analysts, Claudio Irigoyen and Ezequiel Aguirre, argue.

If interest rates in the US rise, they see lower inflows into bonds but higher equity and foreign direct investment inflows.

“Global investors still have large quantities of funds under management parked at negligible rates in dollar-denominated assets,” they said.

“If growth prospects improve, investors will want to put some of those funds to work, preferably in assets of high-growth economies.”

They recommend that investors take long positions in the long end of the Mexican bond/swap curve, as they believe short-term rates are too low, given expectations of policy rate cuts by Banxico – expectations that the Merrill Lynch analysts do not share.

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For Colombia, they recommend long positions in short-term government bonds, since they expect more monetary easing and the long end of the curve “has already rallied too much after the decrease in taxes to foreign investors.”

Late last year the Colombian government cut taxes on foreign investors’ profits from bonds by more than half to 14%, sending yields on its bonds tumbling as investment appetite surged.

The nominal bond curve in Chile “is close to perfectly flat,” the analysts said.

They said they prefer long positions in the short-end, because there are “no additional carry gains from extending duration. “

In Peru, yields are “extremely low” and the Merrill Lynch analysts prefer the long end of the bond curve.

“Alternatively, we recommend purchasing inflation-linked bonds” in Latin Amercia, they said.

“Better growth prospects – the required condition for higher US interest rates – should be associated with higher inflation down the road. And in many instances, inflation-linked bonds appear to be already cheap relative to nominal bonds.”

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