Emerging-market currencies are well up this quarter and repeatedly ascended to record highs.
The Brazilian real has been the top performer this month, followed by Russia’s ruble and Colombia’s peso.
Last week, Brazil’s central bank announced its third interest rate hike in 2021, a 75-basis point increase to 4.25%. It also said it anticipated a similar rise in August. The aggressive tightening has triggered a sharp rally in the Brazilian real.
“Brazil is probably the clearest example of a combination of better growth prospects, reduced political noise, more hawkish central bank and undervalued currency to justify its recent outperformance,”
Bank of America (BofA) strategists wrote.
Russia has also tightened policy sharply this year, raising rates three times, saying the economy is recovering faster than expected and inflation is developing above the bank’s target. Policymakers also said more hikes would be needed over the coming months.
Other emerging market central banks, notably in Latin America and South Africa are likely to follow suit, as economic activity and inflation roar back from a Covid19-driven slump. In comparison, the U.S. Federal Reserve officials signaled they expect to raise interest rates by late 2023.
Recent dollar gains have stalled the momentum in emerging-market currencies. But as developing central banks outpace the Fed in policy tightening, emerging-market currencies could regain their record run against the greenback, according to Bank of Singapore and JPMorgan Asset Management.
“Emerging-market central banks are set to begin raising interest rates well before the Fed,” Mansoor Mohi-uddin, chief economist at Bank of Singapore told Bloomberg. “Over the summer, lower volatility may induce investors to put on seasonal carry trades again to the benefit of higher yielding emerging-market currencies.”
One cannot invest in an emerging market without considering the impact of the U.S. dollar, as there is a strong relationship between emerging market equity and the greenback. In the last 25 years, the correlation between relative performance of emerging markets and developed markets and the U.S. dollar has been -0.35. Although, the U.S. dollar is just one of many factors affecting the performance of emerging markets, it cannot be ignored as it may add additional risk to one’s portfolio.
In a separate matter, the US Federal Reserve announced that it would extend dollar-swap lines with global central banks through the end of the year. The currency program is one of the last remaining Covid-era initiatives the US central bank took to keep world markets flowing.