The Big Idea
Dominican Republic | Easing cycle imminent
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Emerging markets credits benefiting from rating upgrades have the most room to maneuver these days. Costa Rica was the first to cut rates and then Uruguay quickly followed by the Dominican Republic. There is huge participation in local debt markets trade this year with high real rates and a cyclical peak in inflation. The Dominican Republic may offer increasing access offshore to their local markets at an opportune moment: an easing cycle, a resilient foreign exchange rate and a low beta to uncertain external markets. The Central American and Caribbean still represent an attractive region within Latin America for both external and local investment.
The Dominican Republic’s central bank must be getting itchy to initiate easing. Not only has inflation peaked with a clear deceleration this year but the downside risks to growth are also threatening. The Dominican Republic is known for its enviable 5% GDP trend growth with downside risks towards 4% after a deceleration in the first quarter of this year. The latest survey of inflation expectations shows 12-month forward inflation now reverting back within the 4% +/- 1% target band while growth expectations for this year are quickly approaching 4%–a sharp slowdown from 5% last year. There is yet no conviction on the survey for the timing of rate cuts; however, expectations are for a 100 bp decline in policy rates this year. The central bank has kept rates unchanged since November 2022 with real rates now increasing to highly restrictive levels at 2.6% on annual inflation and 6% on annualized monthly inflation in March 2023.
The central bank must soon be reaching an inflection to initiate the easing cycle with the latest post meeting communique referencing the consistent decline in core and headline inflation through April 2023 and noting the restrictive high real rates. There was also a bolded reference to the higher flexibility for the central bank to consider an opportune moment to adopt measures that gradually return growth bask to trend and preserve overall economic stability. This reference suggests a shift on priorities for their reaction function, especially on the latent risks to the global environment for a small, open economy vulnerable to global macro trends.
The initiation of the rate cut cycle would likely motivate further demand for accessing Dominican Republic local markets. There was huge reception for the dual tranche issuance last February with the relative outperformance of the DOP’2033 versus the DOMREP’2031 probably inviting a reassessment of the 2023 financing program this year. There is still $2.8 billion remaining of the $3.5 billion external funding program this year after the net $700 million in new financing raised last February. The supply/demand dynamics may motivate a shift to capture the index demand and the scarcity value of only two outstanding offshore dual currency bonds. Although Dominican Republic Eurobonds remain a popular overweight for EM-indexed investors, the technicals are much worse on the $27 billion stock of outstanding Eurobonds and high beta volatility from ETF funds. The development of the offshore DOP bond markets should require the central bank to manage still low foreign exc hange volatility on the difficulty for investors to hedge FX risk as well as the still cautious stance until inflation normalizes back to 4% target levels.
There has already been a substantial rally on the local market curve with 200 bp to 250 bp of spread tightening since launch of the dual currency bond last February and a further compression between onshore-to-offshore risk premium with the DOP’2033 rallying 290 bp since launch and an additional 3.75% in foreign exchange returns that have been resilient against global financial market volatility. This FX appreciation was also met with slightly higher foreign exchange reserve accumulation of $600 million from February through April 2023. The initial phase of the easing cycle may benefit from further foreign exchange appreciation on the cross-border financial inflows with expectations of still strong performance for the dual currency bonds.
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