Emerging markets offer loophole for low volatility dollar, pound sterling, euro and aussie
– Emerging currencies could be favored in a calm summer
– As market prices see major FX run out of steam
– After emerging market central banks take the lead in raising rates
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Emerging market currencies would provide investors with an escape from the lethargy that could befall major exchange rates this summer if the largest central bank lags behind its more aggressive counterparts in developing economies interest rates in the face of rising inflation.
Currencies have this year been primarily a developed world story of rapid progress on immunization programs in the UK and US, among others, which has fostered a national and international containment process that is now raising expectations of economic growth and inflation in many places.
As a result, prices in some financial markets have changed and now place high probabilities of rising interest rates from mid-end to end of 2022 compared to Bank of Canada, bank of england, Federal Reserve, Bank of Canada and Reserve Bank of Australia among others.
Meanwhile, the Reserve Bank of New Zealand and Norges Bank are seen moving even earlier than that, although the snag for the currency market is that these central banks can do nothing but neglect to meet those expectations for at least a few more months.
“The CAD, GBP and NOK have been the three best performing G10 currencies since the start of the year, with central bank policy perceptions playing a key role in this performance,” said Jane Foley, manager. of the foreign exchange strategy at Rabobank.
Above: The performance of the US dollar against major currencies this year. Source: Netdania Markets.
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The current high expectations of central banks could be nearly impossible to improve for many, if not all, and would be easily disappointed if the recent inflation increases seen in many countries were to fade quickly or if economic recoveries met with obstacles. on their way.
Either way, it will be at least a few months before central banks in developed markets have enough information to decide whether or not to indulge in those betting that labor markets will normalize quickly as the pandemic takes hold. will subside and inflation will prove to be more persistent than expected.
Many exchange rates may have little place in the short term, as central banks wait to see whether reopening economies will live up to expectations and whether emerging price pressures are really as “transient” as they are. generally assume.
This in turn could create a sluggish, low-volatility, and docile environment around major exchange rates, which is a proven recipe for outperformance among emerging market currencies:
Above: dollar index displayed at daily intervals with the pound-dollar rate.
Some analysts say emerging market currencies are likely to be the best performers throughout the summer months, and that this could easily come at the expense of even popular major currencies like the Australian dollar, the pound and the euro.
“After a brief push around the FOMC, currency volatility is down again. We expect it to remain low over the medium term and in particular in the coming months. Carry trades are the natural domain of FX investors in times of low volume. This necessarily means long emerging markets, and every G10 currency is now a potential funding currency, ”says Elsa Lignos, Global Head of Foreign Exchange Strategy at RBC Capital Markets.
Like their major counterparts, many emerging market currencies fell apart after the Fed’s policy decision in June indicated that some rate setters are starting to think it may be appropriate to raise rates as soon as possible, although a handful have stood out from the crowd wherever they haven’t turned the tide due to restless central banks now offering investors enhanced rewards for buying their currencies.
“The artists who stood out in recent weeks have been the BRL, MXN and RUB. Most notably, the BRL has offset the overall trend in emerging currencies by strengthening over the past two weeks despite the Fed’s hawkish policy update, ”said Lee Hardman, currency analyst at MUFG.
Above: MUFG chart showing the performance of the US dollar against emerging market currencies.
Many central banks in the developed world have struggled and, in some cases, failed to generate more inflation in recent years, and enough to meet their targets, so they may be more reluctant to remove price pressures. which temporarily return by raising interest rates than those in the rest of the world.
But emerging market economies, whose currencies had received less attention from investors this year, have a different experience of inflation and some of their central banks are already raising interest rates in order to contain it.
“In the emerging market space, where the experience of inflation tends to be much more perilous than in the G10, various central banks have flexed their muscles,” Foley said. “With the return of the carry trade to the fore, the market will be alert to the possibility of any change in central bank rhetoric.”
The best performing companies so far are mainly concentrated in Central and Eastern Europe as well as in the emerging market space of the Americas.
The hawkish political credentials of the Central Bank of Russia were again demonstrated yesterday when Governor Nabiullina said she was ready to consider a rate hike from 0.25% to 1.00% at her next meeting on July 23, ”MUFG’s Hardman said.
“Unlike central banks in developed markets, they” do not see the acceleration of inflation as transitory, but more persistent “, and aim to react” quickly, but predictably “to rates. We continue to favor emerging currencies where national central banks lead the way in policy tightening, ”adds Hardman.
In Europe the Czech National Bank (CNB) and National Bank of Hungary (NBH) made headlines in Europe last week when the former Czech Republic raised the Czech Republic’s cash rate from 0.25% to 0.50% in its first monetary outflow of the pandemic .
Above: RBC Capital Markets analysis showing an optimal choice of currencies to sell in exchange for emerging market peers.
The CNB said that “interest rates should continue to rise in the second half of this year”, while the BNH raised its base rate from 0.30% to 0.90%.
“Central Europe and the region are experiencing what we believe to be a prolonged period of above target inflation. But how this affects monetary policy will differ across the region. Interest rates in Poland and Hungary are expected to stay low longer than investors think, while the Czech tightening cycle is expected to be more aggressive, ”says Liam Peach, emerging markets economist at Capital economics.
“We believe this will be associated with a marked divergence in the performance of currencies and bonds across the region,” adds Peach.
Meanwhile, and more in North America Banxico surprised the market by raising Mexican interest rates from 0.25% to 4.25%, following in the footsteps of others, although they are by no means the first to offer higher payments, according to traces of Bank of Brazil which delivered its third consecutive interest rate hike this month, raising the South American country’s spot rate to 4.25%.
“We have heard investors express concern that Banxico would struggle to be hawkish, although it is clearly trying to outperform the market with this week’s surprise rise. We still like the short AUD / MXN position and although it has been stable since the start of the year, we are looking for a better performance in the second half of the year, ”said RBC’s Lignos.
“Attractive funding currencies will generally be those that trade as risky assets, but whose returns are associated with safe havens in more normal times. AUD most often emerges as an effective funding currency, ranking first against MXN, RUB and ZAR, ”Lignos adds.