Not all emerging currencies are equal

May 28, 2013

The received wisdom is dollar strength = weaker emerging market currencies. See here for my colleague Mike Dolan’s take on this. But as Mike’s article does point out, all emerging markets are not equal. It follows therefore that any waves of dollar strength and higher U.S. yields will hit them to varying degrees.

ING Bank says in a note sent to clients on Tuesday that emerging currency gains in recent years have been closely tied to foreign investments into domestic bond markets. Recent years have seen a torrent of inflows into local debt, driving down yields on the main GBI-EM index and significantly boosting its market value. Hence, it makes sense to examine how the GBI-EM’s biggest constituents might fare under a scenario of a surging dollar and Treasury yields (In the two years before a Fed tightening cycle commences, 5-year Treasury yields can trade 120-150 basis points higher, ING analysts point out).

In almost every one of the emerging markets examined by ING, spreads over U.S. Treasuries have tightened dramatically since the start of 2012. Ergo, they are vulnerable to correction.

But the ING analysts also look at:

a) correlations between the yield spread and respective currencies’ exchange rates

b) the magnitude of the inflows.

They found the Russian rouble and Mexican peso most tightly correlated to their respective bond spreads over Treasuries. The peso notably is free floating while Russia, worried about weak growth, is less likely to intervene to boost the rouble at present. The ING analysts write:

While the Fed normalising interest rates should not necessarily derail EM investments per se, a disorderly correction in yields probably leaves the Mexican peso most exposed. We are also interested in the rouble’s high positive correlation. A deteriorating ex-energy current account position and the strong dollar story keep us firmly as dollar/rouble buyers on dips.

The Brazilian real, Turkish lira and Malaysian ringgit had the lowest links with bond yield spreads, ING found. With the Brazilian and Turkish central banks having kept their currencies more or less in strict check, that does not seem surprising.

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