EM Rundown: What would a Fed rate hike mean for EM FX?

<p>Thousands of gallons of virtual ink has been spilled on the market implications of the Federal Reserve’s monetary policy meeting decision on Thursda, and we’ll […]</p>

Thousands of gallons of virtual ink has been spilled on the market implications of the Federal Reserve’s monetary policy meeting decision on Thursda, and we’ll undoubtedly see plenty more analysis over the next few days.

One particular area of interest is in emerging markets, where previous decisions by the FOMC (notably the so-called “Taper Tantrum” of 2013) have led to plenty of volatility. Rather than rely on blind prognostication, we wanted to take a close look at previous examples of Fed tightening and their impact on EM FX so that traders can be prepared whenever the FOMC opts to start raising interest rates, whether it’s in three days or three months.

The accepted “wisdom” is that a tightening cycle by the Federal Reserve inevitably leads to outflows from emerging markets, hurting their currencies and markets, and certainly throughout the ‘80s and ‘90s, this adage held true. However, during the two most recent examples of Fed rate hike cycles (beginning in 1999 and 2004), emerging market currencies held up relatively well until global equity markets collapsed.

This relatively strong performance has corresponded with a greater preponderance of floating exchange rates (in contrast to the widely pegged exchange rates) and lower levels of aggregate external debt relative to GDP in most emerging markets. These structural changes mean that there is a more of a cushion between US monetary policy and EM economies than there was twenty or thirty years ago. Therefore, an immediate fall in EM currencies if/when the Federal Reserve starts raising interest rates is far from guaranteed, especially if there no accompanying stock market collapse.

That said, awareness of these two long-term trends can allow traders to hone in on EM currencies that may be most vulnerable when the Fed hikes. In particular, Middle Eastern, dollar-pegged currencies like the Saudi riyal, UAE dirham, and Bahrainian dollar, as well as the Hong Kong dollar, may see their pegs come under pressure, especially with the recent drop in oil prices (for the Middle Eastern currencies) and China’s economic activity (for the Hong Kong dollar).

In addition, currencies with large current account deficits, such as the Turkish lira, Brazilian real, and South African rand could be particularly vulnerable, as those economies are dependent on external capital for borrowing. By contrast, the mostly-Asian emerging market currencies with large current account surpluses, namely the Korean won, Thai bhat, Philippine peso, and even the Russian ruble, should be relatively insulated from Federal Reserve policy.

Even though this weekly report is titled “EM Rundown,” it’s worth reminding readers that emerging markets are not a monolithic entity; astute traders pay attention to the difference between different EM economies and adjust their trading strategies accordingly.

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