Transmission of U.S. Long-term Rate to EM Local Currency Sovereign Bonds

This paper investigates how shocks to the U.S. long-term risk-neutral interest rate influence emerging market local currency sovereign bonds and how domestic investor participation affects this relationship. We focus on the expected-future-short-rate, or risk-neutral, component of U.S. long-term rates, which reflects U.S. monetary policy and serves as a purer from of the global risk-free benchmark, rather than term premia. Using the instrumental variable approach and data on investor types in local currency sovereign bond markets, we have two main findings. First, a rise in the U.S. long-term interest rate leads to an increase in both local currency sovereign yields and term premia in emerging markets. Second, domestic investor participation mitigates these spillover effects from the U.S. interest rate, primarily driven by domestic banks and non-bank institutional investors rather than central banks. These results underscore the importance of policies aimed at broadening and deepening local investor bases to strengthen local market resilience against unexpected external interest-rate shocks.