Domestic sovereign yields puzzle in 2020: falling yields amid a large fiscal shock in emerging markets

In mid-2020, domestic sovereign long-term bond yields in many emerging market economies (EMs) quickly stabilized at or below their pre-COVID levels despite a persistent widening of expected budget deficits and outflows of foreign investors. The phenomenon was present even in countries with well-known political impediments to sustainable fiscal policies. It raised concerns about whether domestic yields remained reflective of countries' fundamentals and whether the pandemic-driven fiscal stress was correctly priced in into the yields. To address it, we dissect the variation of EM yield curves during 2020 and study their evolution compared to several advanced economies. As market expectations surveys lacked reliability during the shock, we identified the drivers of the curves' variation through a series of interviews with market participants and portfolio managers. The main finding is that while investors' restored belief in the short-run credibility of countercyclical monetary policy response helped anchor short-term forward rates at historically low levels in virtually all EMs, the lack of credibility of fiscal and monetary policies in the long run kept longer-term forward rates at significantly distressed levels in countries with pronounced political constraints that tended to undermine the feasibility of necessary fiscal adjustments.