Goldman, JPMorgan Pin Emerging-Market Bets on Hawks Beating Fed

(Bloomberg) -- Emerging-market currencies hit by a hawkish Federal Reserve may soon regain their record run against the dollar on expectations that developing central banks may outpace their U.S. counterpart in policy tightening.

The currencies of Brazil, the Czech Republic, Hungary and Poland -- countries that delivered multiple rate hikes or are expected to do so soon -- are retaining quarterly gains and outperforming peers. In comparison, the Fed has signaled it’s likely to lift interest rates only in 2023. Goldman Sachs Group Inc. and JPMorgan Asset Management say that once the dollar’s support from a positioning shift fades, emerging-market currencies could once again roar back.

“A more hawkish Fed could provide a hawkish and FX-friendly impulse for some EM central banks that were thinking of their own policy shifts,” and “may nudge others significantly in that direction,” Goldman strategists including Zach Pandl and Kamakshya Trivedi wrote in a note Sunday.

“Our main arguments for EM FX appreciation over the medium and long runs -- value, hiking cycles that contribute to domestic carry rebuilds, and vaccine-led cyclical recoveries -- should continue to provide support over the summer in a way that is not entirely determined by Fed decision-making,” the strategists added.

U.S. financial conditions are closely correlated with demand for risk assets, including emerging-market stocks and currencies. While taper talk has been the focus of investors’ concerns, they should be watching for signs of tightening financial conditions, which could trigger a selloff, according to Neels Heyneke, a strategist at Nedbank Group Ltd. in Johannesburg.

That’s not happening yet, with U.S. conditions still near the loosest on record, according to the Goldman Sachs U.S. Financial Conditions index. While gauges of emerging-market stocks and currencies have pulled back from all-time highs, they’re still well up this quarter.

With the Fed unlikely to hike in 2021 or 2022, “monetary and financial conditions should remain easy for some time,” said Didier Lambert, JPMorgan Asset Management’s lead portfolio manager for emerging-market fixed income. “EM central banks able to rein in inflation expectations in a credible way -- such as Russia, Czech Republic or Brazil -- may see greater demand for their currencies.”

While some commodities took a hit after the Fed’s latest rate signal, others remain supportive of emerging-market currencies linked to raw-material prices. Raw materials like copper, coal and iron ore hit all-time highs last month, with a rebound in the world’s largest economies stoking demand for metals and energy when supplies are still constrained.

That’s prompting Aberdeen Asset Management to take advantage of any weakness to add to its bullish bets on commodity-linked currencies such as the Brazilian real, as well as the Chilean and Colombian pesos.

“If anything, this is ratification that global growth is strong and so is the demand for commodities,” said Edwin Gutierrez, head of emerging-market sovereign debt at Aberdeen in London. “But let’s see how much of a shake-out there is in those.”

Cyclical Recovery

JPMorgan Asset Management plans to use any market volatility to invest in most emerging-market currencies that will benefit from a cyclical recovery and in selective high-yielding securities. Bullish positions in developing currencies aren’t “overextended,” suggesting that potential losses from a stronger dollar will be limited, said Lambert.

The shift toward tighter monetary policy in developing nations isn’t uniform, however. Some are continuing to support growth as the coronavirus continues to spread, or a new wave of cases emerges.

Central banks in Thailand and the Philippines look set to keep interest rates on hold this week, as the region battles persistent coronavirus outbreaks with only a fraction of the population vaccinated. Poland wants to keep monetary policy loose until the economic rebound is well under way, despite surging inflation.

That means investors should be looking for relative-value trades rather than buying the basket, according to Bank of America Securities, which favors Poland’s zloty over other Central and Eastern European currencies given cheaper valuations and a still relatively dovish central bank, giving it “more scope to reprice when they turn hawkish,” strategists led by David Hauner said in a report.

Brazil Outperforms

The Brazilian real has been the top performer among emerging-market currencies this month, followed by commodity-linked peers such as Russia’s ruble and Colombia’s peso. The forint, zloty and koruna have underperformed.

Brazil’s monetary authority hiked its key interest rate by 75 basis points and opened the door to even bigger increases on Wednesday amid surging inflation forecasts. The nation is among the first to increase its key rate to pre-pandemic levels, taking a more aggressive stance to battle inflationary pressures.

“Brazil is probably the clearest example of a combination of better growth prospects, reduced political noise, more hawkish central bank and undervalued currency to justify its recent outperformance,” the BofA strategists wrote.

Carry Return

Emerging-market local-currency debt posted its biggest weekly drop since March 2020 in the five days through Friday. It’s often seen as the most susceptible to any rise in the dollar or U.S. yields because either of those would reduce the carry return. A Bloomberg News study has identified that a 25-basis-point increase in yields in a month would be the tipping point for moves in higher-yielding currencies such as the Turkish lira, South African rand and Mexican peso.

“While we believe emerging-market currencies are undervalued on a real effective basis, the carry is fairly limited in most currencies,” said Nicholas Ferres, chief investment officer at Singapore-based hedge fund Vantage Point, who prefers to hold Asian stocks.

Some frontier currencies such as the Egyptian pound and Ghanaian cedi will probably hold up better than most of their peers given their “enormous” real-yield advantage, according to Fidelity International.

“A market shake-out over the summer will provide an attractive entry point to get back into emerging-market dollar debt, currencies and local duration,” said Paul Greer, a London-based money manager at the firm, which oversees about $700 billion. “We expect the total returns for the asset class to be better in the second half than in the first half.”

Listen to the EM Weekly Podcast: Mexico, Hungary Rates; Sanctions on Russia

Rate Decisions

• Hungary’s central bank on Tuesday is poised to start one of the region’s first monetary-tightening cycles to combat the fastest inflation in the European Union
  • The forint was one of the biggest losers in emerging markets last week as economists’ forecasts on the size of a potential rate increase vary
  • Traders doubted the central bank will deliver “decisive” monetary tightening, as promised by a deputy governor
• On Wednesday, the Czech central bank is predicted by almost all economists to follow suit with a quarter-point hike to 0.5%
• Thailand and the Philippines will probably keep borrowing costs unchanged on Wednesday and Thursday, respectively
  • Policy makers from both countries are likely to signal “that they won’t adjust policy for quite a while to come,” said Frederic Neumann, co-head of Asian economics research at HSBC Holdings Plc. “With domestic demand still hobbled by Covid-19 restrictions, there is little risk that rising commodity prices will trigger a surge in consumer prices”
  • The Thai baht and the Philippine peso each fell more than 1% last week
• China’s one-year loan prime rate -- the reference rate for bank loans to companies -- remained at 3.85% for a 14th month
  • The five-year rate -- the reference rate for mortgages -- was kept at 4.65%

• Mexico’s central bank is expected to leave its key interest rate steady for a fourth month on Thursday

  • Traders will watch for any guidance on future policy as the nation’s TIIE curve prices in more than 70 basis points of hikes in the rest of 2021
  • Traders will also monitor Mexico’s April retail sales data on Wednesday, bi-weekly inflation for the first part of June on Thursday, and April economic activity on Friday

• Brazil’s central bank will release minutes from its most recent policy meeting on Tuesday, which may offer detail on the 75-basis-point Selic increase

  • The policy makers will also release a quarterly inflation report on Thursday, which will will likely bring a significant upgrade to the BCB’s growth forecast, according to Bloomberg Economics
  • Brazil will post mid-June IPCA numbers on current account data for May on Friday

What Else to Watch

• South Korea’s exports rose 29.5% in the first 20 days of June from a year earlier as the global economy shakes off the effects of the pandemic

  • Bloomberg Economics expects tight supply and sustained demand for tech products to continue to buoy exports in the months ahead
• South Africa’s inflation probably accelerated to 5.2% in May, the highest in more than two years. That would be in line with the projection model of the central bank, which indicated last month that its interest rate will increase before the end of the year
  • The rand was the hardest hit emerging-market currency last week
• In Argentina, investors will watch first-quarter gross domestic product figures on Wednesday for signs of a rebound compared with earlier in the pandemic

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