The short and happy life of EM currencies

The Dollar has fallen significantly versus EM currencies over the last year after a four-year rally (Source: here)

The US dollar has fallen steadily versus Emerging Markets (EM) currencies over the past twelve months following four years of strength. This is very good news for EM economies, which tend to be severely finance-constrained and whose access to international finance often depends on global risk sentiment rather than the intrinsic value propositions in each of their markets.  

Undoubtedly, the rally in EM currencies is prompting many policy-makers in developing countries to ask why it is happening at all. And why now?

Although one should never completely discount anything in the world of finance, I do not believe the sudden performance of EM currencies versus the Dollar is due to some fundamental epiphany on the part of global investors. Wrongly, in my view, most of them still view EM countries as a bunch of whacky nations at the riskiest end of the investment spectrum to which allocations can only be made on a highly opportunistic basis rather than as part of a core allocation, say, in accordance with EM's GDP share.

As a result of this view, EM economies tend to be structurally under-financed and it is likely, in my view, that EM will continue to be structurally under-invested for the foreseeable future.

Unless, that is, global investors miraculously develop some ability to think rationally all of a sudden.

Specialist EM investors are of course extremely familiar with this reality. Indeed, the reason why they invest in EM is precisely the structural under-investment within the asset class; EM is attractive because it is an under-invested asset class. Under-investment means you get paid more than the risk you take.

EM policy-makers also understand this reality extremely well. They tend to be grateful for whatever crumbs fall from the big table, even knowing that the bounty is likely to be temporary.

For now, the rising tide in EM FX is unambiguously good news. When investors buy EM currencies, they usually end up buying some local bonds too, because bonds give them access to longer (and therefore higher) rates versus FX implied yields.

Moreover, over time as inflows push down bond yields across the curve, the cost of borrowing for the entire EM economy falls, which helps both consumers and businesses.

Incidentally, stronger EM FX also reflects the fact that EM equities have been receiving inflows. Fresh funding is now going directly to EM companies, which will have money to invest. Growth should therefore pick up, particularly since EM has been so deprived of capital for such a long time.

Anyway, back to the question of why EM currencies are rallying versus the Dollar. The answer is that the rally in EM FX almost certainly has nothing to do with EM itself; it is all about the falling US dollar.

A falling Dollar pushes up all non-Dollar currencies. EM currencies just happen to be the most 'gogo' of the bunch (and hence a good bell-weather too).

So why is the Dollar falling? Whenever we talk about the Dollar it is worth remembering that the Greenback behaves almost exactly the opposite to EM currencies; while investors are habitually sceptical about EM, they are routinely bullish the Dollar, almost regardless of the news. Underpinning the bullish Dollar view is the pure fiction that US Treasuries are a risk-free asset (for more on this, see here).

The second Trump Administration is a case in point; Trump has spent the first year of his second term as president squandering every major advantage the US derives from its privileged economic, financial, and military position. Trump has abandoned America's commitment to free trade and turned his back on long-standing allies. Besides, Trump is actively undermining core American institutions, such as the rule of law, democracy, and human rights, both at home and overseas. Yet, US markets have been remarkably resilient, or at least far more resilient than any other market would have been under similar circumstances.

Until now, that is.

If there is one area where investors really worry about political interference it is the Federal Reserve. The Dollar began to fall when Trump first began to attack Fed Chairman Jerome Powell (for a bit of colour on this see here). The latest Dollar dive was triggered by news that Kevin Warsh would succeed Powell. Markets believe that Warsh will be Trump’s biatch.

In reality, Trump may not quite have it all is own way with Warsh. Even if he does, US interest rates are not set by the Fed Chairman on his own, but rather by the Federal Open Markets Committee, which is stuffed to brim with hawkish regional governors.

Still, for now currency traders are flogging the idea that Warsh will make some head-way in cutting rates. If this view is correct, the resulting lower Fed funds rate will directly undermine the attractiveness of the Dollar versus other currencies. In turn, foreign holders of US Treasury bonds may become less inclined to hold Treasuries due to expected FX losses. When they sell, they will buy bonds in other markets instead, pushing down the Dollar and other currencies up, perhaps even EM currencies.

There are also potential fiscal consequences of Warsh's appointment. For one, he is expected to wind down the Fed's bond buying programme (that is, unwind Quantitative Easing). This will have two main implications. First, the yield curve will steepen, which will hurt US housing. And you know what they say: where the housing market goes so the economy follows. Second, it will get harder to fund the enormous US fiscal deficit.

With respect to the latter, Warsh may actually be on point. After all, Donald Trump is on track to become a lame duck after the November mid-term elections, so he may soon have to worry far more about impeachment than additional fiscal stimulus. Either way, it seems that US economic growth - the other major support of the Dollar after rates - could well falter.

Finally, I would be remiss not to mention that EM FX is benefitting from benign positioning. Investors do not own much EM. After a four-year upturn, everyone is still very long the Dollar, while hardly anyone owns EM.

May the short and happy life of EM currencies last, for a time at least!  

The End