Strains on emerging market currencies building on US Fed’s intentions, political headwinds

Emerging market currencies are weakening in the face of US rate expectations and political uncertainty, casting doubt on investors’ hopes that they can withstand a mix of pressures that have in the past thrown them into turmoil, reports Financial Times.

A sell-off in the last five days has added to the strain on EM currencies, taking the Turkish lira’s decline over the past month to seven percent. The Mexican peso, the Brazilian real, the Colombian peso and the South African rand have each lost more than 3 percent in the period, while the Russian rouble has fallen 2.3 percent.

“It’s been very wobbly,” said Luis Costa at Citigroup. The weakness in these currencies has unfolded despite a backdrop of record low levels of volatility and continued risk appetite in developed markets, he added. “It’s a bit head-scratching for investors.”

However, Nigeria’s local currency, the naira has been relatively firm since the beginning of November with currency analysts projecting a gain of 1.6 percent against the US dollar by month end.

usdforcast.com specifically see the naira exchanging at N358.86/$ at the end of November, representing 1.66 percent gain.

Nigeria’s efforts at broadening non-oil revenue base have so far proven largely unsuccessful, Moody’s says

But across EM, improving economies, smaller current account deficits and healthier amounts of foreign exchange reserves had given investors belief that the currencies’ sensitivity to the US dollar and interest rates was waning.

Jay Powell, chosen last week by Donald Trump to be the next chair of the Federal Reserve, said last month that the challenges for EM from the normalisation of rates in the US and elsewhere should be “manageable”.

Confidence in EM currencies has also been buoyed by the reduction in risk factors that have previously been damaging, such as falling commodity prices and anxiety over the outlook for China’s economy. Deutsche Bank’s EM currency index, for example, showed an almost 12 percent gain for the year through to early September.

Since then, the dollar index measuring the US currency against a basket of its peers has rallied 3.6 percent, driven by Federal Reserve hawkishness and hopes of US tax reform.

EM high-yield currencies are “hyper-sensitive” to US interest rate moves, said Stephen Jen at Eurizon SLJ Capital, despite the recovery in commodity prices, and will be the first domino to fall when interest rates spike.

As US rates rise, investment will likely flow out of EM

Win Thin, Brown Brothers Harriman

“Most investors understand the reliance of many savings-deficit EM economies on dollar-denominated debt,” said Mr Jen. “But my sense is that the elasticity of these currencies, with respect to US interest rates, has risen sharply.”

According to Win Thin at Brown Brothers Harriman, the market is underestimating the Fed’s 2018 and 2019 tightening path. “As US rates rise, investment will likely flow out of EM,” Mr Thin cautioned.

In recent weeks, EM currencies have not been helped by the spectre of political volatility hovering over many of their economies. The worst-performing EM currencies in the past month for the most part face heightened political risk well into 2018, Thin added, noting that elections are scheduled for next year in Brazil, Colombia and Mexico, and for South Africa and Turkey in 2019.

A tightening in global liquidity is also having a negative impact on EM, said Wike Groenenberg, head of BNP Paribas’ EM strategy. Oil’s spike this week to $64 a barrel should help liquidity in EM, but its rise was also a response to Gulf tensions “so it’s not helpful for countries in that region”.

But EM in the longer run remains healthy, said Goldman Sachs analyst Kamakshya Trivedi.

“This is an asset class with undemanding valuations, a generous level of real carry and exposure to the synchronised growth recovery across the EM world,” he added.