Fed paves the way for more emerging currency gains

(Bloomberg) — Central banks in developing countries will be featured this week as signs that the Federal Reserve will be in no hurry to raise interest rates pave the way for further gains in emerging market currencies.

Officials in Poland, Russia, Peru and Malaysia meet to decide the direction of monetary policy with the view that interest rates in the US will remain low for longer, a message that Fed Chairman Jerome Powell was keen to emphasize at Jackson Hole . And that means any signs of monetary tightening in emerging markets could bring carry trade, interest rate arbitrage operations, back into the game, further boosting earnings, as was the case with the Chilean peso last week.

While the Emerging Markets carry trade has returned just 0.5% in the first half, Bloomberg’s EM Carry Index has risen nearly 2% since late July, and high-yielding but volatile currencies like the Lira. Turkey and South Africa’s rand lead the rally. The MSCI Emerging Markets Currency Index posted gains in nine of the last 11 sessions.

“Emerging market currencies may be at an sweet spot,” said Christopher Shiells, an analyst at Informa Global Markets in London, who is betting on the real, Russian ruble and Mexican peso, which are likely to perform better in coming months.

The weak US labor market data on Friday bolstered predictions that the Fed will hold interest rates even when it starts to scale back emergency stimulus. As a result, the cost of borrowing dollars to invest in higher-yielding assets would remain low, a strategy that could be positive for investors given that the Fed’s focus on stimulating economic recovery is also likely to keep the dollar under control.

James Barrineau, head of Emerging Markets Debt at Schroder Investment, said Powell, at least at this juncture, appears to have achieved a reduction in stimulus favorable to emerging markets. “The main thing Powell did was to separate the discussion about reducing the stimulus from rising interest rates. And he indicated that rate hikes are likely to be far away. This resulted in a weaker dollar, which is a strong positive for emerging markets.”

Decoupling the stimulus reduction from interest rate hikes has also given new impetus to the currencies of the first countries to raise rates, such as Brazil and Russia, whose performance is beginning to slow after strong gains this year. The ruble and real are the best performers among emerging markets since Powell’s Jackson Hole speech on Aug. 27, which gave officials room to react to economic fundamentals rather than guessing at the Fed’s steps.

“Emerging market central banks have already reacted to higher inflation and raised interest rates, creating a buffer if economic growth starts to surprise on the downside next year,” said Anders Faergemann, manager of PineBridge Investments in London, who described Powell’s speech in Jackson Hole as a “watershed”. With inflation in many developing countries near the peak, “these countries already have positive real interest rates that would tend to support exchange rates,” he said.

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