Why Currency Traders Should Pay Attention to Emerging Markets
The past two months have not been kind to emerging-market currencies. After a strong start to the year, the developing-nation basket has struggled to stem the decline against a more assertive U.S. dollar. Appetite for dollar-denominated assets is expected to grow as the Federal Reserve eyes a more aggressive tightening schedule.
A Growing Source of Instability
A synchronized global recovery was supposed to promote stability for emerging-market currencies. Instead, exogenous forces tied to U.S. monetary policy have triggered a mass exodus from the developing world since the second quarter began.
The MSCI International Emerging Market Currency Index peaked at multi-year highs in early April. Since then, it has declined roughly 3.2%. Over the same period, the U.S. dollar index (DXY) has gained nearly 4.5%, reversing one if its worst starts to the year on record.
DXY tracks the greenback against a basket of six currencies: euro, yen, British pound, Swiss franc, Swedish krona and Canadian dollar.
The MSCI EM Currency Index tracks dozens of currencies across three regions: Latin America, Eurasia and Asia. The Asia sub-index, which includes the Chinese Renminbi and South Korean won, is allocated half the weighting.
The Turkish lira and Argentine peso have been the source of considerable upheaval in recent weeks. In the case of Turkey, a widening budget deficit and President Erdogan’s plan to have a more direct role in monetary policy triggered a flight from lira-denominated assets. The central bank’s unexpected 300-basis point increase to the benchmark rate last week failed to support the currency.
For Argentina, the peso plunged after the government approached the International Monetary Fund (IMF) about a new line of credit. The central bank had previously raided interest rates to 40% after raiding the country’s reserves.
A stronger dollar also weighed down both currencies, which often suffer from liquidity shortfalls on the major exchanges. The lira and peso are heavily influenced by the dollar since most of their foreign funding is denominated in the greenback.
The lira was the world’s best performing currency on Monday after the central bank provided clarity on its interest rate regime. However, Turkey remains on the hot seat over double-digit inflation, a struggling economy and political instability. Combined, these forces have spooked foreign investors.
The Dollar: In the Driver’s Seat
Though Turkey and Argentina continue to face domestic challenges, the U.S. dollar has been the biggest currency risk of all.
The DXY basket strengthened again on Monday, reaching its highest level in over five months as currency speculators continued to bet on a faster rate-hike cycle. According to Fed Fund futures prices, a sizable minority of traders believes the central bank will raise interest rates four times this year, one more than the consensus forecast.
Federal Open Market Committee (FOMC) officials will meet in two weeks to vote on interest rates. A 25-basis point increase has already been priced in by the market. The Fed’s perceived hawkishness is well reflected in bond yields, which have surged to their highest level in at least seven years.
Currency risks for emerging markets are expected to continue for the foreseeable future, though the outlook depends heavily on U.S. monetary policy. The good news is assets like the MSCI EM Currency Index are heavily weighted toward Asian markets, which are benefiting from China’s unexpected economic resilience. In addition to Turkey and Argentina, South Africa is another source of vulnerability amid a surge in political violence.
Featured image courtesy of Shutterstock.