Emerging-Market Currency Rally to Record Now Faces Fed Reckoning

An employee uses a counting machine to count South African Rand notes. (Photographer: Jason Alden/Bloomberg)

Emerging-Market Currency Rally to Record Now Faces Fed Reckoning

After a 13% advance from post-pandemic lows to a record high, the rally in emerging-market currencies looks to be fizzling out.

Gains in the South African rand -- this year’s best performer -- have stalled. Options traders are adding to bearish wagers on the Russian ruble despite hawkish comments last week from the central bank chief. And the Chilean peso suffered its biggest drop in three weeks on Tuesday as a rout in copper prices dims the outlook of the country’s terms of trade.

Implied volatility in developing currencies is also rising for the first time in two weeks, according to a JPMorgan Chase & Co. gauge, raising hedging costs and denting the appeal of higher-yielding currencies.

Emerging-Market Currency Rally to Record Now Faces Fed Reckoning

Morgan Stanley’s quant models say it’s time to turn defensive amid signs of excessive risk appetite in emerging markets.. For Saxo Bank and Societe Generale, the trigger could come as soon as Wednesday, should the Federal Reserve indicate a willingness to pull back support sooner than investors expect, lifting the dollar.

“The long-EM trade may be overextended in the strongest performers,” said John Hardy, head of FX strategy at Saxo Bank in Hellerup, Denmark. “If there are to be any fireworks in the dollar post-FOMC, they may be most dramatic in EM.”

This quarter, emerging-market currencies have risen about 3% and repeatedly ascended to record highs. That’s thanks in part to more subdued Treasury yields, which receded from a 14-month high seen in March.

The benefit has been clearest in the South African rand, this year’s standout developing currency. Dollar-rand’s 90-day correlation with 10-year U.S. borrowing costs stands at about 0.4, the strongest since 2017.

Emerging-Market Currency Rally to Record Now Faces Fed Reckoning

Yet yields could get a renewed catalyst to break higher, should the Fed affirm -- or exceed -- economist expectations for policy makers to signal a tapering in bond purchases in August or September. The consensus view may also shift on Wednesday to show officials projecting at least one interest-rate hike in 2023, earlier than the 2024 liftoff previously viewed as most likely.

Another bad omen for emerging markets is the fact that investors remain short on the U.S. dollar, according to Kit Juckes, chief foreign-exchange strategist at Societe Generale in London. Leveraged funds have been bearish on the greenback for seven of the past eight weeks, having flipped from a bullish stance in April.

“It may be that the market is most exposed in short dollar positions against some of the most-traded emerging currencies,” Juckes wrote in a note.

Societe Generale advised investors to stay neutral on emerging-market currencies as it expects a “flattish aggregate” return by the end of 2021.

For Morgan Stanley, it’s a signal for investors to consider rotating out of higher-risk strategies such as carry trades and move into cheaper currencies that would offer value should risk sentiment turn. Those include the Polish zloty, Brazilian real and South Korean won, Andres Jaime, a New York-based strategist at the firm, wrote in a note.

“Our models consistently suggest a more defensive approach,” Jaime added. “This week marks an important inflection point.”

©2021 Bloomberg L.P.

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