Monday, January 24

Bears take a turn in emerging currencies

Currency watchers are monitoring bearish calls from emerging markets, betting that the asset class is now in a better position to withstand rate hikes from the Federal Reserve when they occur.

Developing currencies “are likely close to bottoming out,” as the Fed rate takeoff has tended to peak for the dollar, Morgan Stanley strategists led by James Lord wrote in a report this week. Meanwhile, strategists at Citigroup Inc. recently cut some bullish bets in dollars against emerging market currencies.

MSCI Inc.’s indicator for developing currencies rose to a four-month high on Wednesday, ignoring a rise in two-year Treasury yields to pre-pandemic levels. They have been backed by central banks that led rate hikes in 2021, providing a buffer against higher US rates.

“It’s a common misperception that EM FX underperforms when the Fed tightens up,” said Claudia Calich, director of emerging markets debt at M&G Investments in London. “They tend to depreciate up front, so when the Fed starts to move, they actually tend to do relatively well.”

Calich likes the Mexican and Chilean pesos and the Czech crown among the currencies of economies with strong external accounts or where inflation could soon peak.

The Hungarian forint, the Chilean peso and the South African rand have led the way since the beginning of the year among the 22 currencies of developing countries followed by Bloomberg. Each has gained about 3% against the dollar.

The gap between the short-term returns of some of the largest emerging markets and the US is above 500 basis points, after widening about 167 basis points from pre-pandemic levels, according to the manager of Eurizon SLJ Capital funds. This buffer will serve them well as US rates rise, said the firm, which has overweight positions in currencies likely to benefit from global economic expansion, including the Indian rupee.

“Emerging currencies have come a long way in pricing a tighter political environment in the US, with market participants now largely on the sidelines,” said money managers Alan Wilson and Joana Freire. in an email. “That said, the specter of an increasingly aggressive Fed continues to haunt our markets and further weakness in the emerging market currency cannot be ruled out.”

Capital fluxes

A Fed rate hike also typically propels emerging market currencies through the equity path. Higher Treasury yields reduce demand for US stocks and reduce investors’ need for dollars. Free capital often seeks higher returns in the riskier developing world, generating flows to local assets.

Between June 2004 and June 2006, when the Fed raised rates 425 basis points, emerging market stocks rose 80%, far outpacing the 12% advance of the S&P 500. This coincided with demand for currencies. locals, which propelled the MSCI FX index higher. 22%. Similarly, between December 2015 and December 2018, a 225 basis point increase in rates generated a 22% gain for emerging market stocks, slightly more than the S&P 500, and was accompanied by a rally in the 10% for the forex indicator.

Unless the Fed needs to go higher than reflected in the recent dot chart estimates, “local emerging market markets should perform better in 2022,” said Calich of M&G Investments.

© 2022 Bloomberg

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