FX Monthly – Under the spell of the taper

by: Georgette Boele

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Emerging market currencies have been hit by rising US yields

Our currency indices show significant drops in EM currencies against the dollar since the start of May. This reflects disappointing economic data, the decline in commodity prices and the rise of political unrest in a number of countries. But the trigger for the large sell-off in emerging market currencies has been the jump in US yields following the Fed’s indication that it will taper its bond purchases before the end of the year. As a result, this led to unwinding of the large capital flows that had supported emerging market currencies and assets more generally. Currencies with weak fundamentals (the INR, BRL, ZAR, TRY and IDR) have been particularly hard hit. However, the authorities have generally put in place various measures to stem the decline and there are tentative signs that the tide is turning, though it is far too early to declare that the worst is over.

EM currencies to recover until Fed hikes come into view

The combination of rising US long-term interest rates and an emerging market sell-off has brought back unpleasant memories of past emerging market crises. However, there are also major differences. In particular, emerging market fundaments look much healthier than in the past. We expect the global economy to strengthen in the coming quarters. At the same time, we expect the Fed to withdraw monetary stimulus only very gradually. This combination should revive investor risk appetite. At the same time stronger global growth will support EM exports. Against this background we expect EM currencies to regain some traction over the next few months, though a stronger dollar is likely in the longer term, especially once Fed rate hikes – likely in 2015 – come into view during the course of next year. We keep MXN and PLN (versus EUR) as our EM top picks. MXN will profit from a strong US economy and PLN is attractive from growth and yield perspective. We have taken the ZAR out our top picks. We still believe that the ZAR will recover but the large swings seen in the last months, and external financial vulnerabilities, makes it undesirable as top pick. The CNY remains our Asia top pick although we now foresee a somewhat slower appreciation path.

USD ascent to start

Fundamentals are consistent with a stronger dollar against advanced economy currencies this year and next, and more broadly next year. A big factor behind this view is that the US economy will outperform, while monetary policy differentials will also favour the dollar. In Europe, we expect the central banks to continue to fight strongly to dampen expectations of early hikes in short-term interest rates. Meanwhile, other dollar-positive fundamentals will increasingly come to the fore. The shrinking budget deficit and shale energy revolution are leading to a shrinking of the country’s external imbalances.