In focus

Could Fed tapering spark an EM currency rally?

Global fixed income markets have become focused on the sharp rise in short-dated bond yields in developed countries.

This may signal that the market thinks developed market central banks are behind the curve on inflation.

We think the rise in these short term developed market (DM) bond yields has contributed to the underperformance of emerging market (EM) currencies relative to what has been a stable dollar.

By contrast, EM central banks have already begun to address the spike in prices, although some still have much work to do.

Short term interest rates in EM have accurately reflected hiking expectations, rather than excessive angst.

Could tapering confirmation actually spur EM currency support?

Normally, hawkish DM central banks make for poor EM currency prospects. However, some firmer rhetoric that at a minimum calms rates markets, could lead to a catch up in EM under-performance.

In normal times, returns for local currency denominated EM debt (EMD) investors closely follow the path of the US dollar.

The chart below shows an unusual divergence this month - the dollar has been almost exactly flat and local currency EMD returns have been nearly -1% at the time of writing. This is despite a positive half-percent rates gain.

The last week was been a mixed one for DM central bank messages. The Bank of Canada sprung a hawkish surprise by saying it may raise rates as early as April 2022, while the European Central Bank sat on its hands.

Meanwhile year-to-date short-term rates in the UK, Canada and Australia have risen over 60 basis points, and 30 basis points in the US since 1 September. With the dollar stable and equity risk benign, that has created a substantial headwind for EM.

This week’s meeting of the Federal Open Market Committee will test whether markets become more comfortable with DM central bank responses to the threat of inflation.

This confidence could be regained with a combination of slightly firmer rhetoric and less severe inflation fears. If so, we think EM currencies are poised to outperform, absent a significant dollar rally.