Rate Hikes May Boost EMFX

Emerging markets currencies (EMFX) adjusted sharply downwards following a more hawkish Federal Reserve (Fed) outlook, but we believe there are several tailwinds that may allow EMFX to continue the rally that began in April and drive local currency sovereign bond returns higher. Although the market reacted swiftly to the re-alignment of the dot plot¹ and prospect of tapering, rate increases are still not expected by the Fed until late 2023. Meanwhile, several emerging markets central banks have already started hiking aggressively, and emerging markets as a whole are biased towards higher rates.

Forecasted EM and DM Policy Rates

Source: J.P. Morgan. Forecasts by J.P. Morgan research team based on economic projections and current central bank policies.

In mid-June, Brazil’s central bank hiked its SELIC benchmark rate² by 75 basis points in order to combat higher inflation, bringing it back to pre-pandemic levels with a continued tightening bias. Russia also hiked this month, and BRL and RUB were among the top performing currencies month-to-date (as of June 22, 2021). Hungary and the Czech Republic are also expected to continue to raise rates. Even Mexico, so closely tied with the U.S. economy, pre-empted the Fed with a surprise rate hike in late June. Not all countries are ready to hike, preferring to support economic growth in the face of higher case counts in some areas. Fortunately, many emerging markets have the luxury of positive real rates.

In addition to pushing up the carry earned on local currency bonds, rate hikes may support local currencies as an offset to tighter financial conditions in the U.S. As the perceived hawkishness of the Fed increases, we believe more emerging markets central banks may act quicker in an effort to not fall behind. When accompanied by higher economic growth, driven by continued vaccine roll-out as well as the potential for higher commodity prices, many currencies may stand to benefit. To the extent the recent decline in metals and other raw materials has impacted certain currencies, investors expecting inflationary pressures to resume may find an attractive entry point through emerging markets local currency bonds. It’s also important to remember that overall currency valuations remain at extremely depressed levels relative to history.