The Asian rally may just be a 'false dawn' as the Federal Reserve is not done hiking

(Bloomberg) — Amid a broad rally in Asia on expectations of little action from the Federal Reserve, some strategists warned that the market’s reaction may be overblown.

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Asian bonds and currencies jumped on Friday amid rising hopes of a peak in US inflation. The won and baht led gains, with both currencies strengthening more than 2 percent against the dollar, with their respective 10-year benchmark yields falling at least 15 basis points. The rally may just be a “false dawn,” according to Mizuho Bank Ltd.

Markets may be disappointed as the Fed is nowhere near ending its campaign for higher interest rates given still high inflation. Emerging market assets have rallied since late July as investors mistook the Fed for a dovish turn, only to give up gains after hawkish comments from FOMC members and Fed Chairman Jerome Powell in Jackson Hole. A 1.1% loss in EM Asia local currency bonds in August widened to more than 4% in September, the worst monthly return on record since 2008.

“My initial feeling is that it really looks like overexuberance because of the cautious positioning,” said Vishnu Varathan, head of economics and strategy at Mizuho Bank Ltd. in Singapore. My suspicion is that for a Fed that will “keep going until the job’s done,” and to the extent that peak Fed Funds rates are still bound to rise, this narrowing of the US-Asian inflation differential would be more somewhat desirable for EM Assets in Asia, he adds.

Inflows into Indonesia’s foreign bonds and Thai debt in August, the first in many months, were completely reversed as international investors withdrew in September and October.

“One day of lower correction in government bond yields is probably not enough to make local currency bonds attractive to foreign investors,” said Francis Cheung, Singapore-based interest rate strategist at Oversea-Chinese Banking Corp.

After the US CPI report, the Fed’s overnight index swaps priced almost zero probability of a 75 basis point hike in December, which would be a step down from the Fed’s four consecutive 75 basis point rate hikes so far.

“Interest rates are still rising at both the Fed and Asian central banks, so there may be limits to how far bonds can rally,” said Galvin Chia, EM FX strategist at Natwest Markets in Singapore.

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