EMD Relative weekly notes: Week Ending October 25, 2019
The End of USD Correlation for FX?
It used to be that EM investors, particularly local currency investors, had a simple mantra to follow: watch the US dollar. A dollar trending stronger meant a high probability of losses—some substantial—while a falling dollar meant gains. Intuitively, this makes sense: a rising dollar represents capital flows into the US and away from EM—typically leading to weaker currencies, more inflation, higher interest rates, lower growth prospects, etc.
Those days may be over.
Thanks to global QE and coordinated slower global economic growth, inflation rates in EM countries are now less volatile and are actually declining. That, in turn, makes currency volatility more subdued, and with that policy framework in place real interest rates can decline. It's hard to overstate how impactful that is, as it leads to lower fiscal costs for local funding and better growth prospects overall.
Figure 1 tells the story. It represents the last five years of USD local currency returns for EM investors in light blue and the inverted USD index. The stronger dollar in 2015 crushed local returns (worst year ever with a negative 15%), 2016 was fairly stable and a positive year as the Fed stalled its hiking cycle. A falling dollar in 2017 led to robust returns (a positive 15%), and a dollar reversal in 2018 led to yet another negative year of a 6% loss.
Sources: Bloomberg, data as of October 25, 2019. Chart depicts JPMorgan GBI-EM Global Diversified Index performance against the DXY US Dollar Index performance (inverted on the RHS). Performance shown reflects past performance, which is no guarantee of future results. The value of investments can go down as well as up and is not guaranteed.
But that is where the story turns.
The dollar has risen about 3% this year, and—to date—the local currency index has returned nearly 11%. Most EM countries are cutting rates (Russia, Indonesia, Brazil, Mexico) while central European countries already have nearly zero real rates.
Yield-starved investors are getting comfortable with less volatile currency risks given the high carry relative to the developed markets, along with the allure of higher prices for local bonds. In a world where QE has apparently become a permanent fixture, we believe investors should be structurally more comfortable with local currency exposures, even as the dollar gyrates around other developed currencies.
The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.