Market participants are beginning to mull the impact of a rate hike, expected in the second half of next year, as brightening US economic prospects boost dollar optimism.
While US growth has historically powered optimism over EM growth prospects – thanks to export-hungry US consumers – the sensitivity of EM FX to the US rate cycle has increased, argues Nomura.
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| We wanted to know if there was a case for being long the dollar against EM currencies and the answer is yes Jens Nordvig |
“Historically, emerging-markets currencies have been substantially less sensitive to spikes in US rates than their G10 counterparts,” according to Nomura’s research.
“For example, the beta of BRL to US rates is 1.4%, compared with 6.0% for EUR. Generally speaking, a 100 basis point move in USD interest rates (two-year swap rate) results in a 5% to 10% move in G10 FX and a 1% to 5% move in EM FX. This finding is also true if the regression window is set specifically at the start of each hiking cycle.”
It found that, based on average sensitivities since 2001, GBP and EUR have the highest beta to dollar rates, with several other G10 currencies also having high sensitivities – but data show currency betas to US rates have been rising over time, especially for EM currencies.
“The recent price action suggests that EM currencies are more vulnerable to spikes in US short rates than was the case in previous cycles,” says Nomura.
Trading after the announcement of strong Q2 GDP data in the US saw EM currencies generally underperform G10 currencies, with EURMXN higher and TRYJPY lower, for example. Viewed in isolation, this indicates EM FX now has a higher sensitivity to US rates than G10 currencies, Nomura says.
Jens Nordvig, global head of FX strategy at Nomura, adds: “Typically you see the biggest adjustment in the run-up to tightening, not once it has happened,” he says. “I expect to see a response in the next few months, and once the tightening actually starts it to be largely priced in.”
Phenomenon
The phenomenon has not been detected across all EMs equally, with some – such as Russia and Indonesia – far more sensitive to political developments closer to home than to US rates. At the other end of the spectrum, the Turkish lira and Brazilian real have proved particularly sensitive to US rates sentiment.
This research has given Nomura a long dollar conviction on a broad basis.
“We wanted to know if there was a case for being long the dollar against EM currencies and the answer is yes – the argument is stronger than before,” says Nordvig. It has taken this exposure via dollar call options as a hedge in case sentiment swings suddenly.
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Sensitivity is evident in G10 markets too.
“Both sterling and the euro have remained sensitive to any speculation regarding a US rate hike, mainly due to the fact that market participants are trying to avoid missing out on any sizeable price movement,” says Kamil Amin, currency analyst at Caxton FX.
“With data likely to remain the key determinant as to when both the Bank of England (BoE) and Federal Reserve will act, we expect to see sensitivity remain in the GBP/USD rate until either central bank sets a clear time frame. At this point we will see a monumental shift in momentum, most likely to be in favour of sterling, as the BoE is still expected to be the first to tighten policy.”
In EMs, Caxton “expects volatility to remain, mainly due to the fact that investors are trying to be as risk adverse as possible”, says Amin.
“In the near term we expect to see some added volatility across EM markets on the back of any strong US data, continued geopolitical tensions and weakened domestic data, but it is unlikely that we will see another heavy sell-off,” predicts Amin.
Policy shocks
Increasing leverage in EMs increases their sensitivity to policy shocks, but the changing relationship between EM currencies and US rates is being driven by the popularity of the carry trade, says Nick Beecroft, senior market analyst at Saxo Bank, with investments in EMs funded by cheap dollars.
Nomura believes it can also be partly explained by the convergence between emerging and G10 markets. In previous tightening cycles, such as 2004-06, EMs benefited from bullish investor sentiment, but this time around such sentiment appears to have peaked and be on the wane, says Nordvig, even pre-dating the ‘taper tantrum’ of last summer.
It can also be viewed as a consequence of extreme policy measures, including six years of zero interest rates and repeated bouts of quantitative easing, which can only have distorted the relationships between assets.
Investors are still likely to assess fundamentals, says Beecroft, with high current-account deficit currencies likely to be hit first and hardest by sentiment shifts around US rates in the absence of real market panic. Concerns about the impact of rates rises might also be offset to some extent by growing optimism around the outlook for the US economy, he adds.