Investors expecting more than 50 basis points of easing from the Federal Reserve (Fed) this year may find themselves disappointed on New Year’s Eve.
While interest rate futures are pricing in a 100% probability of a quarter-point rate cut in September after a benign July headline inflation reading, overall, current data shows that the Fed has less easing capacity than global markets seem to be clamouring for.
The Consumer Price Index (CPI) print earlier this week showed that on an annual basis prices rose 2.7%, less than the market had anticipated. It was widely interpreted as showing that tariffs had not pushed up prices and in response, investors ramped up expectations for as many as three cuts by the end of the year.
Treasury Secretary Scott Bessent fuelled the narrative and extended the political pressure on the Fed by suggesting the central bank should embark on a series of cuts, starting with a 50 basis point lowering next month.
Impact on EM debt
Fed policy shifts affect all asset classes, but emerging market (EM) debt performance is especially sensitive to it. Investors have grown accustomed to Fed accommodation providing multiple tailwinds: search-for-yield flows into higher yielding assets, dollar weakness that eases currency pressures, and the general risk-on sentiment that compresses spreads.
Current market positioning reflects this dynamic. EM bond spreads have reached levels not seen since before the 2008 Global Financial Crisis, based on current market data, with local currency bonds trading at all-time tight spreads versus US Treasuries. Credit differentiation has also compressed significantly where countries rated double-B to single-B now trade at virtually identical spreads, regardless of their underlying fiscal profiles.
This convergence doesn’t reflect informed optimism about EM fundamentals. Instead, it points to mechanical buying driven by fixed ETF allocations and algorithmic trading strategies that deploy capital without fundamental analysis. When markets stop distinguishing between creditworthy borrowers and potential problem cases, they typically signal that liquidity conditions, rather than economic reality, are driving valuations.
Figure 1. Spreads between EM and US rates are near all-time low
Source: Bloomberg as at 17 July 2025. The GBI EM GD Index reflects the JPMorgan Government Bond Index-Emerging Markets Global Diversified Index. UST 5-year yield reflects the U.S. 5-year Treasury. The GBI EM GD Index ex (Ch+Ma+Th) reflects the JPMorgan Government Bond Index-Emerging Markets Global Diversified Index and excludes China, Malaysia and Thailand.
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However, those liquidity conditions are shifting. Two temporary boosts to the financial system supported markets through July, and both are now unwinding.
First, the Fed slowed its money-draining operations earlier this year, reducing monthly liquidity withdrawal from US$25 billion to just US$5 billion. Think of it as the Fed taking its foot off the brake pedal. Second, the Treasury spent down US$559 billion from its Federal Reserve account between February and July while navigating debt ceiling constraints. When the Treasury spends this cash, it flows directly into markets – effectively like months of money printing.
Now both dynamics are reversing. The Treasury is rebuilding its cash reserves, pulling money back out of the system. Meanwhile, Fed Governor Christopher Waller recently indicated that bank reserves could fall to US$2.7 trillion from today’s US$3.3 trillion while still maintaining adequate liquidity. Translation: don't expect the Fed to ride to the rescue with more accommodation.
Inflation trends not as benign as they seem
This liquidity drain comes at an awkward time for Fed policy. Core inflation jumped to 3.1% in July, higher than expected and an increase from June's 2.9% reading. Furthermore, roughly half of all consumer price components are still rising at annual rates above 3-4%.
Much of the recent improvement in headline inflation came from falling energy prices rather than a broad-based cooling. If oil prices stabilise or rise, that tailwind disappears quickly. That would further reduce the Fed’s room to cut aggressively without risking a return to higher inflation.
Figure 2. US July 2025 Consumer Price Index, selected categories
Source: US Bureau of Labor Statistics as at 12 July 2025.
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Meanwhile, US government spending is providing less economic support. Federal deficit reduction created a 0.9% drag on GDP between February and June on a twelve-month rolling basis. As this fiscal boost fades, the economy will need to stand more on its own two feet.
Look at the fundamentals
Yet futures markets remain convinced that substantial Fed easing lies ahead, creating a notable gap between expectations and the constraints facing policymakers. As liquidity conditions normalise and the Fed's hands remain somewhat tied by inflation, the mechanical flows that compressed EM spreads could face headwinds.
This environment may highlight the value of fundamental credit analysis rather than riding broad market trends. When easy money becomes less easy, the differences between good and bad borrowers tend to matter again.
All data sourced from Bloomberg unless otherwise stated.
Author: Guillermo Osses, Head of Emerging Market Debt Strategies, Discretionary at Man Group.
Disclaimer: Emerging market investments carry heightened risks including currency volatility, political instability, and liquidity constraints..
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