US yields set to tighten grip on emerging-market currencies

Bloomberg

Slowing economic recovery amid a resurgent pandemic is leaving emerging-market currencies vulnerable to a selloff if Treasury yields rise again.
While the influence of US borrowing costs on developing-nation currencies has waned in recent months, it may return to prominence for riskier assets as the cushioning effects from China’s growth rebound and low inflation weaken, according to money managers including Fidelity International and Credit Agricole CIB.
“A very sharp, quick move higher in front-end US real yields would be an extremely bad outcome for emerging-market currencies,” said Paul Greer, a money manager at Fidelity in London, which oversees about $700 billion. “Gyrations on the US rates curve, particularly in the real-yield space, will remain the dominant driver of sentiment in the very near term.”
Emerging-market currencies got a glimpse of the Treasury-led turbulence last week, when they posted the biggest loss since July 9 as the two-year yield jumped. The pain could deepen if key economic data including South African consumer prices confirm forecasts for a worsening macro picture.
Beyond this week’s reports, traders’ big cue on the direction of Federal Reserve policy may come from the Jackson Hole symposium later this month.
The benchmark gauge for emerging-market currencies has fallen about 2% from a record in June and is on the verge of erasing its gains this year. While its 120-day correlation with the US two-year yield is holding near zero, meaning they’re moving independently of each other, money managers caution against complacency.
The dwindling correlation comes after Treasury yields softened in the past two months. Even though lower US rates encouraged investors to seek higher yields, emerging-market exchange rates failed to benefit amid concern highly infectious delta variant of the coronavirus would hamper domestic growth.
“Growth and liquidity might actually be fiercest headwinds in the second half and also explain why falling US yields didn’t buoy EM currencies in July,” said Witold Bahrke, a Copenhagen-based senior macro strategist
at Nordea Investment.
While the sensitivity of emerging-market currencies to Treasury moves has fluctuated over the years, US yields can never be ruled out as an influence on local-market returns, according to Aviva Investors.
“One of the largest risks to the asset class remains a more destabilising rise in USreal yields, which impairs equity and credit channels and leads to a more significant capital flight on EM markets,” said Kurt Knowlson, Aviva senior portfolio manager for emerging-market debt in London.
In the event of a substantial and rapid increase in short-term Treasury yields, the highest-yielding currencies within emerging markets may suffer the most. In particular, the Indonesian rupiah will see its return advantage erode and vulnerability increase because the nations are more reliant on external financing, according to Credit Agricole CIB.
Meanwhile, currencies seen to be backed by stronger growth, better Covid-19 management and governments less reliant on external financing will be more resilient, said Eddie Cheung, senior emerging-markets strategist at Credit Agricole in Hong Kong, touting the Taiwanese
dollar and Chinese yuan.
For the moment, though, the spread of the delta variant and lockdowns are weighing on the growth outlook for developing economies, where vaccination programs lag behind those in North America and Europe. China’s rising economic risks dim allure of developing-nation currencies further.
“The asset class will face a number of headwinds, including declining growth differentials with the US, sensitivity to the delta variant due to less advanced vaccine walls, relatively sticky inflation and concerns over Chinese regulatory and fiscal policy,” said Oliver Harvey, a London-based strategist at Deutsche Bank AG. “The one offset is relatively low levels of broader volatility in markets.