A daily summary and commentary of events and factors that affect the global markets, with a particular emphasis on the foreign exchange markets.
Twist of FAIT
Share this story:
Andrew Kositkun Senior FX Advisor
When emerging market (EM) central banks were aggressively easing during the heart of the pandemic, they were counting on the “reach-for-yield” dynamic that played out during much of the previous business cycle to continue to support their currencies and yield spreads. With the benefit of hindsight, we know that things generally went according to plan, with most EM currencies performing well.
This year has been a different story, with U.S. yields turning sharply higher and reflation expectations putting upward pressure on EM yields and downward pressure on some EM currencies. Normally, reflation isn’t negative for EM because it typically comes in a risk-on environment that leads to U.S. dollar weakness and tight yield spreads. This is especially true if reflation is led by China, as this leads to higher commodity prices, which is supportive of commodity-producing EM economies.
The concern this time around is that the U.S. is driving reflation expectations. This is due to unprecedented fiscal stimulus, the Federal Reserve’s commitment to its new flexible average inflation targeting (FIAT) framework and vaccine distribution outperformance. As a result, expected U.S. economic outperformance has supported the dollar and steepened EM yield curves. In response, central banks in Brazil, Russia and Turkey all raised rates by 75 basis points (bps), 25 bps and 200 bps, respectively. The Bank of Mexico stayed on hold, contrary to prior expectations of a rate cut.
In response to rate hikes, Turkish President Recep Tayyip Erdogan replaced Turkey’s central bank governor. Certainly, Turkey is not a representative example, but it wouldn’t be surprising to see political pushback to rate hikes in other countries as well as higher rates hinder an economic recovery that has barely begun.
However, there are also costs to not hiking. EM central bankers often do not get the benefit of the doubt from markets when it comes to their ability to bring down inflation to target. Against a backdrop of very easy monetary policy, any signs of inflationary pressures would hurt EM currencies and lead to a negative feedback loop — a weaker currency means higher import prices, which means higher inflation, which means a weaker currency. This cycle between inflation and exchange rates is made worse because EM currencies don’t benefit from reserve currency demand like the U.S. dollar does.
Moreover, the current rise in U.S. yields is just the first step in a three-step process through which Fed normalization will impact EMs. The second step will be the actual tapering of asset purchases followed by the third step of realized rate hikes. Unfortunately for EM central banks, each step gets progressively more challenging.
But there are also reasons for optimism over the medium term. For now, Fed hikes are a distant concern, and increased vaccine distribution later this year should be a tailwind to the EM recovery, limiting the extent to which U.S. outperformance impacts EM assets. Of course, it should also be noted that differences among EMs are as important as the common themes discussed above. Countries with low debt/GDP ratios, large foreign exchange reserves, positive vaccine distribution outlooks, and proactive and credible central banks should do better. While credibility is hard to quantify, it is a function of historical success in controlling inflation and central bank independence. As such, Turkey is an obvious concern, as is Brazil, due to its high debt/GDP ratio and COVID-19 situation. Conversely, most Ems in Asia should find themselves in a favorable position.
Want to learn more about international finance, economics, and global events? Sign up for our other Foreign Exchange emails and videos!
Follow City National Bank on social media:
Non-deposit investment products:
Are not FDIC insured,
Are not deposits or other obligations of City National Bank and are not guaranteed by City National Bank, and
Are subject to investment risks, including possible loss of the principal invested.
This report is for general information and education only and was compiled from data and sources believed to be reliable. City National Bank does not warrant that it is accurate or complete. Opinions expressed and estimates or projections given are those of the authors as of the date of the report with no obligation to update or notify of inaccuracy or change. This report is not a recommendation or an offer or solicitation to buy or sell any financial instrument discussed. It is not specific investment advice. Financial instruments discussed may not be suitable for the reader. Readers must make independent investment decisions based on their own investment objectives and financial situations. Prices and financial instruments discussed are subject to change without notice. Instruments denominated in a foreign currency are subject to exchange rate and other risks. City National Bank (and its clients or associated persons) may engage in transactions inconsistent with this report and may buy from or sell to clients or others the financial instruments discussed on a principal basis. Past performance is not an indication of future results. This report may not be reproduced, distributed or further published by any person without the written consent of City National Bank. Please cite source when quoting.
Now accepting scholarship apps Celebrating 40 years of service -- A loan to an innovative company -- Affording your dream home -- Mergers and a new branch in Raleigh View this email in your browser Forward to a friend
Your Market News update for May 30, 2019 | View online Market News News that's moving the market now As Trade-War Worries Linger, Market Seems to Lack Buying Conviction May 30, 2019 8:40 AM | JJ Kinahan 6 min read | Daily Market Update