US yields set to tighten their grip on emerging market currencies

Bundles of Indonesian rupiah banknotes seen on a desk at a currency exchange office in Jakarta. The rupiah has weakened more than 2% this year.

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 $700bn. “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 China’s industrial production and 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 the highly infectious delta variant of the coronavirus would hamper domestic growth. “Growth and liquidity might actually be the 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. “The medium-term outlook on EM currencies is primarily being determined by a trifecta of yields, growth dynamics and liquidity.” 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 US real 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 and Turkish lira will see their 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 programmes lag behind those in North America and Europe. China’s rising economic risks dim the 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. China reports a slew of July data on Monday from retail sales, industrial production to fixed assets ex-rural as a fresh Covid outbreak dents the nation’s outlook. The maturity of 700bn yuan ($108bn) of medium-term policy loans is also in focus on Monday in order to gauge the central bank’s policy stance. China publishes one- and five-year Loan Prime Rates on Friday amid a backdrop of resurging coronavirus cases. The one-year rate, currently at 3.85%, is the reference rate for bank loans to companies. The five-year, at 4.65%, is the rate for mortgages. Readings of second-quarter gross-domestic product across developing economies will offer investors insight into how renewed lockdowns and virus concerns are affecting growth. Thailand will report on Monday that GDP probably grew 6.6% in the April-to-June period from a year earlier, after five quarters of contraction. The focus will likely be on the evolving growth trajectory, given the ongoing pandemic and rising political risks from the latest anti-government protests, according to ING Groep NV. The baht is the worst-performing emerging Asian currency this year. A reading of Colombian GDP on Tuesday will likely show a decline in the second quarter from the previous three months amid protests and renewed lockdowns, according to Bloomberg Economics. Chile will post its second-quarter GDP on Wednesday. Bloomberg Economics expects the economy to have extended its uptrend, climbing above the pre-pandemic level. The nation will release second-quarter current-account numbers on the same day. Bank Indonesia will likely keep the benchmark rate unchanged at 3.5% on Thursday to support economic growth as the government takes measures to control the spread of the delta variant. Southeast Asia’s largest economy snapped a year of contractions in the second quarter but annual growth in the third quarter could slow after mobility curbs were imposed. The rupiah has weakened more than 2% this year. Taiwan is expected to report on Friday export orders moderated in July but will remain in double-digit growth. In South Africa, data on Wednesday may show consumer-price growth in July slowed to around 4.7%, close to the 4.5% midpoint of the central bank’s target band.