Central banks’ long-standing strategy of raising interest rates to defend currencies is failing this time to work its magic in emerging markets.
A gauge of developing country currencies has sunk to the weakest level since March 2020 relative to average local bond yields. That suggests investors are dismissing the lure of rising interest rates, worrying instead about the toxic combination of slower global growth and faster inflation.
As a supply contraction hits their economies and skyrockets consumer prices, emerging market central banks are rushing to minimize the damage with higher rates. But that also runs the risk of stifling a fragile recovery from the slowdown fueled by the pandemic. That dilemma will resonate with policymakers in Russia, Indonesia, Turkey and Hungary this week when they decide on tariffs.
“It’s a delicate balancing act between limiting the hit and not over-adjusting when global demand has clearly passed its peak,” said Witold Bahrke, a senior macro strategist at Nordea Investment based in Copenhagen. “Walking at an even faster pace would risk a double whammy for emerging economies.”
Central banks are finding that rate hikes alone won’t bring investors back when growth is a question mark. The Brazilian real has plummeted 4.2% since September 22, when its policy makers raised its benchmark rate. The Polish zloty has lost value against both the euro and the dollar after borrowing costs rose on October 6. The Czech koruna is also lower since a rise on Sept. 30.
Emerging economies are expected to register a combined growth of 6.5% in 2021, recovering from a 0.6% contraction last year. However, that would reduce its growth advantage over developed economies to 1.2 percentage points, from 3.1 percentage points. Some investors see this narrowing gap as a brake on the need to buy riskier assets.
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Developing nations have already lost their growth advantage during the Covid-19 lockdowns, as they provided much smaller stimulus packages to their economies than either the US or Europe. Now, rate hikes threaten to further erode economic expansion.
China reported weaker growth in the third quarter on Monday as housing and energy crises hurt the economy. Gross domestic product expanded 4.9% from a year earlier, down from the 7.9% previously reported in the prior quarter and compared to a median forecast of 5% in a Bloomberg survey of economists.
In this context, some investors are betting on opportunities of relative value, focusing on emerging economies that have achieved an optimal combination of growth and inflation control. Fidelity International Ltd. prefers Russia and Brazil, where price increases appear to be near their peaks. On the other hand, avoid central European countries as inflationary pressures may persist until early next year.
“We like bond markets where we feel like central banks are ahead of the inflation curve and are already in a tightening cycle,” said Paul Greer, a London-based money manager at Fidelity.
So what makes an emerging market ideal in these turbulent times? Most investors say that Russia has the answers.
The nation has a widely respected central banker in Elvira Nabiullina, whose determination to fight inflation is common knowledge in the markets. It also has a current account surplus and one of the largest foreign exchange reserves in the world. And when the windfall from rising oil prices is added to the mix, investors start to see the ruble as irresistible. The coin has gained almost 2% this month and is the best performer this year in emerging markets.
Goldman Sachs Group Inc. strategist Ian Tomb said the long ruble is the bank’s preferred trade on the rise due to oil prices, but that was not the currency’s only appeal.
“A variety of factors, including carry advantages and external balances, support our continued preference for the ruble,” he wrote in a note.
These are the events and data to take into account this week:
- Russia’s central bank will raise its key interest rate by at least 25 basis points to 7% on Friday. The Economy Ministry warned last week that inflation is on track to reach almost double the central bank’s goal by year-end, even after 250 basis points of increases this year.
- The Hungarian National Bank is forecast to keep its key rate unchanged on Tuesday after a surprise 15 basis point hike in September, half the amount in each of the previous three months.
- In Turkey, policy makers will likely cut rates on Thursday, with some economists predicting a reduction of as much as 1 percentage point to 17%. The lira plummeted to a record last week after President Recep Tayyip Erdogan fired policy makers who were wary of cutting rates further.
- Indonesia’s central bank is expected to hold its benchmark rate at 3.5% on Tuesday. The nation’s five-year bond yield fell to an eight-year low last week.
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