(Bloomberg) — Emerging-market currencies are powering ahead on the back of a weaker dollar, but there are a number of danger signs suggesting their recent gains may be about to end.
Doubts over the ability of emerging economies to combat the coronavirus have seen their exchange rates underperform developed ones during a five-month slide in the dollar. A rapid volley of interest-rate cuts to combat the pandemic has also reduced the attractiveness of EM currencies as targets for carry trades. At the same time, a lack of clarity on the Federal Reserve’s new policy goals may cause investors to be more reluctant to put their money into risk assets.
“Concerns surrounding the economic impact of Covid-19 on emerging markets and their ability to deal with a prolonged crisis dominate investor sentiment” and may see them prefer developed-market assets, said Zsolt Papp, an emerging markets debt investment specialist at JPMorgan Asset Management in London. Markets are looking for a combination of economic data and a slow down or stabilization of new infections, he said.
The following four charts suggest the road to recovery for EM currencies may be far from over:
Emerging currencies are underperforming their advanced-nation peers by a record, according to data compiled by Bloomberg starting in 1973. The ratio of the Federal Reserve’s trade-weighted nominal dollar indexes against developing and developed foreign economies has jumped since the outbreak of the virus in March and has set a succession of new highs in recent weeks.
U.S.-listed exchange-traded funds tracking emerging-markets stocks and bonds have seen combined outflows of $16.5 billion this year. While money trickled back in July, there’s limited scope for increased allocation to developing-nation bonds as investors were already overweight before the pandemic, said Jason Daw, head of emerging-markets strategy for Societe Generale SA in Singapore. A dearth of rally-leading tech and health care-related stocks in emerging markets is capping the attractiveness of EM equities, according to Sim Moh Siong, a currency strategist at Bank of Singapore Ltd.
The recent slowdown in the euro’s rally is posing another threat to emerging currencies, especially those that do substantial trade with the euro area and those from the more open economies, according to a recent Bloomberg study. Elevated speculative positioning in the euro is leaving it vulnerable to a significant pullback, potentially spilling over into developing currencies.
Waning Carry Appeal
Emerging-market carry trades have become less popular as central bank rate cuts have put downward pressure on bond yields. An index that measures returns from borrowing in dollars and investing in eight high-yielding emerging currencies including the Brazilian real and Indonesian rupiah is below its 10-year average after dropping to a decade low in April. While Fed Chairman Jerome Powell’s speech at Jackson Hole boosted the measure by the most in two years Friday, it’s still down nearly 8% this year.