Currency watchers are reining in bearish emerging-market calls, betting that the asset class is now in a better position to withstand Federal Reserve rate hikes when they come.
Developing currencies are “likely close to bottoming out” as a Fed rates liftoff has tended to mark a peak for the dollar, Morgan Stanley strategists led by James Lord wrote in a report this week. Citigroup Inc. strategists, meanwhile, recently cut some bullish dollar wagers against emerging-market currencies.
MSCI Inc.’s gauge for developing currencies climbed to a four-month high on Wednesday, shrugging off a surge in Treasury two-year yields to pre-pandemic levels. They’ve been backed by central banks that led the charge in rate hikes in 2021, providing a buffer against higher US rates.
“It is a common mis-perception that EM FX fares poorly when the Fed tightens,” said Claudia Calich, head of emerging-market debt at M&G Investments in London. “They tend to depreciate in advance so that, by the time the Fed starts moving, they actually tend to perform relatively well.”
Calich likes the Mexican and Chilean pesos and the Czech koruna among currencies of economies with strong external accounts or where inflation may soon peak.
The Hungarian forint, the Chilean peso and the South African rand are leading the advance since the start of the year among 22 developing-nation currencies tracked by Bloomberg. Each have gained about 3% against the dollar.
The gap between the short-end yields of some of the biggest emerging markets and the US is above 500 basis points, after widening by about 167 basis points from pre-pandemic levels, according to fund manager Eurizon SLJ Capital. This buffer will serve them well as US rates rise, said the firm, which has overweight positions in currencies that are likely to benefit from global economic expansion, including the Indian rupee.
“EM currencies have come a long way in pricing a tighter policy environment in the US, with market participants now largely on the sidelines,” money managers Alan Wilson and Joana Freire said in a email. “That said, the specter of an increasingly hawkish Fed continues to haunt our markets and further EM currency weakness cannot be ruled out.”
A Fed rates lift-off also typically boosts emerging-market currencies through the equity route. Higher Treasury yields curb demand for US stocks and reduce investors’ need for dollars. The capital freed up often looks for higher returns in the riskier developing world, sparking flows into local assets.
Between June 2004 and June 2006, when the Fed raised rates by 425 basis points, emerging-market stocks rallied 80%, vastly outperforming a 12% advance for the S&P 500. This coincided with demand for local currencies, pushing the MSCI FX gauge up 22%. Similarly, between December 2015 and December 2018, a 225 basis-point increase in rates saw a 22% gain for emerging-market stocks, slightly more than the S&P 500, and accompanied by a 10% rally for the currency gauge.
Unless the Fed needs to hike by more than what is reflected in recent dot plot estimates, “EM local markets should fare better in 2022,” M&G Investments’ Calich said.