Bears rule emerging markets as central banks battle Omicron

Dubai

IF EMERGING-market central banks were having a tough time shoring up their currencies as the Federal Reserve steps up its scaling back of monetary stimulus, their task just got a whole lot harder.

Worries over the emergence of the Omicron Covid-19 variant sent risk assets into a tailspin last Friday (Nov 26), tipping the MSCI's gauge of developing-world currencies into deficit for the year and potentially its first annual decline in three years.

Central banks in the developing world were being enfeebled by the dollar's renewed vigour long before Omicron was identified, with policy tightening from South Korea to Russia and Brazil doing little to stem the currency losses that are fuelling inflation.

The biggest losers this month are Mexico's peso, South Africa's rand and Hungary's forint, all currencies from countries that have raised interest rates in November. This has put bearish investors in the ascendant.

"Any factors which limit visibility makes life more difficult for central banks," said Viktor Szabo, a senior investment manager at abrdn in London.

"But an increasing number of emerging-market central banks start to realise that the question of whether inflation is transitory or not is not really relevant at this stage. Inflation is high and sticky, even if caused mainly by supply-side shocks, and can de-anchor inflation expectations and put pressure on currencies."

The threat of a more serious variant could also push key mature-market policy makers, such as the Fed and European Central Bank, to turn more dovish, which could balance out the need for more aggressive tightening in developing nations, said Olga Yangol, head of emerging-markets strategy at Credit Agricole in New York.

"The variant may indeed hammer emerging markets harder than other assets, in particular high beta currencies in Latin America and South Asia, which are more sensitive to risk sentiment and more exposed to energy and tourism - the sectors that get the most impacted by the pandemic," she said.

Political meddling has not helped.

Turkish President Recep Tayyip Erdogan's campaign for lower rates sent the lira into free fall last week.

The currency extended declines on Monday after he said he would never advocate interest-rate increases. Data to be released on Friday will probably show that the nation's inflation spiked higher than 20 per cent in November.

The Mexican peso slumped last week as President Andres Manuel Lopez Obrador's nomination of a little-known finance ministry official to lead Banxico fuelled concern about possible government interference in the central bank's independence.

"Any sign of government interference in monetary policy will be punished by markets immediately, as long as global monetary headwinds are stiffening," said Witold Bahrke, a Copenhagen-based senior macro strategist at Nordea Investment.

"Although the primary reason for us to be underweight emerging-market currencies is tightening global monetary conditions, this is reinforcing the bearish case for the market."

The correlation of emerging-market currencies to short-term Treasuries is near the strongest level since 2014, underscoring the potential fallout from higher US interest rates. Investors are hedging against the risk of wider price swings as the dollar climbed to the highest since July 2020.

JPMorgan Chase & Co's gauge of implied volatility in developing currencies rose last week above 10 per cent for the first time since April.

Real rates, which strip out inflation, in most developing economies remain below zero, even after tightening.

This is dimming the appeal of emerging-market assets as US yields rise and concern over the durability of the recovery in the developing economies deepens.

Investors will get further clues on the health of emerging markets in the coming days, with China's official purchasing manager indexes due for release and gross domestic product numbers scheduled from Turkey to India and Brazil.

Hungary, which had trailed central European peers Czech Republic and Poland on the policy-tightening path, delivered its third interest rate increase in two weeks on Thursday, yet it failed to stop the forint from tumbling to a record low.

Meanwhile, Brazil's central bank president, Roberto Campos Neto, who presided over the world's most aggressive tightening cycle this year, cautioned on Wednesday against raising interest rates too fast despite his concern about above-target inflation.

The real is down more than 7 per cent this year, despite 575 basis points of rate increases by the central bank, which has also signalled another 150 basis-point hike in prospect next month. Political and fiscal risks led traders to shrug off the Selic increases.

"We expect currencies to remain under pressure into year-end and probably into early 2022," said Paul Greer, a London-based money manager at Fidelity International, whose developing-nation debt fund outperformed 94 per cent of peers this year. "It is difficult for emerging-market currencies to compete with the US dollar at present." BLOOMBERG