Snapshot

Room to run: why the EM currency rally still has legs


With investor optimism surging on the back of successful trials of Covid-19 vaccines, many are turning their focus to more growth-sensitive, potentially higher-return, higher-risk areas.

Emerging market (EM) currencies and local currency bonds are drawing attention and inflows. Local currency bonds gained over 5% in November, as currencies appreciated over 4% versus the US dollar, based on JP Morgan indices.

Investors might now question the ability of EM currencies to continue to appreciate, but there is plenty of room to run.

Value in emerging market currencies

Real effective exchange rates (trade-weighted exchange rates for currencies versus a basket of others) cheapened severely in the years of the quantitative easing (QE) taper and the rate hikes which followed. From 2013-2015, EM currency index cumulative returns were down nearly 30%.

We think local currency EM bonds are likely to outperform US dollar-denominated debt in the coming quarters, in large part due to potential for currency appreciation. The returns from bonds are likely to be partially constrained by lower local yields.

Despite the 6% returns for the past two months, EM currencies have barely begun to make up for the sharp fall in real value seen over time.

Additionally, the risk that this cheapness of EM currencies is eroded by higher inflation is low. Nominal currency appreciation will curb inflationary pressures, but more importantly central bank credibility has improved and the volatility of inflation has shifted and remained decisively lower.

These factors together suggest there is a good chance of further healthy currency appreciation across a significant part of EM, amid a weak environment for the US dollar.

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