The value of the U.S. dollar has marched higher following the Federal Reserve’s latest lift in interest rates, posing a continued threat to certain emerging market currencies.
The rise in the USD has created challenging conditions for many EM countries, including increased debt servicing costs as their local currencies slide, as well as higher commodities prices, and more expensive U.S. exports.
The Fed’s ongoing tightening of monetary policy has generally exacerbated conditions, with its latest rate hike preceding key central bank rate decisions in the Asia-Pacific region in the week ahead, including from the Reserve Bank of India (RBI) and the Reserve Bank of Australia (RBA).
The Fed’s Open Market Committee elected Wednesday to raise the target range for the federal funds rate to 2.0-2.25%, on the back of positive momentum in the domestic labor market and inflation near the central bank’s 2% objective.
Also, the third reading of second-quarter GDP came in as expected at 4.2% Thursday, reinforcing optimism about U.S. economic expansion, while month- and quarter-end positioning, as well as Italian economic policy concerns further contributed to the USD’s rally before cooling down.
Marc Chandler, global head of currency strategy at Brown Brothers Harriman, observed ahead of the weekend that the USD's post-Fed gains had been extended, though the upside momentum appeared to be stalling.
The U.S. dollar index (DXY) was quoted up around 0.3% intraday Friday to more than US$95.25.
However, the appreciation of the USD, coupled with FOMC monetary policy tightening, as well as a significant shift in U.S.-led global trade policies, have recently contributed to a plunge in certain EM currencies, including the Argentine peso, Turkish lira and South African rand, among others.
Amid this activity, equity investors have been generally exiting EM funds, while credit spreads in these countries have been widening.
Lipper reported net outflows of US$0.093bn in EM equity funds for the week ended September 26, and debt in August had posted negative returns, with Turkey, Venezuela and Argentina mainly to blame for the underperformance.
Other countries’ currencies have also been suffering against this backdrop, including India and Australia, which have each been beset by their respective issues.
IHS Markit economists recently noted that some of the key headwinds facing the Indian economy include higher global oil prices, monetary policy tightening, as well as EM capital outflows.
Market participants have also been eyeing the weakening of India’s rupee (INR) against the U.S. dollar, which has been pressuring input prices in the country’s manufacturing sector. The Nikkei India Manufacturing PMI for August had showed that operating conditions improved at the slowest pace since May, driven by slower gains in output and new orders.
Against the landscape, the RBI elected in early August to increase its policy repo rate by 25bps to 6.5%, with the aim of achieving its 4% area inflation target, and the market widely expects an additional 25bp increase when the RBI next decides on its rate on Friday, October 5.
Among other concerns, the central bank said global trade has lost some traction due to intensifying trade wars, as well as uncertainty over Brexit negotiations.
The RBI further noted that “crude oil prices continue to be volatile and vulnerable to both upside and downside risks. In particular, while geopolitical tensions and supply disruptions remain an upside risk to oil prices, the fall in global demand due to further intensification of protectionist trade policies could pull down oil prices.”
While an oil price decline could alleviate some of the upward pressure on the country’s input costs, U.S.-imposed sanctions on Iranian oil exports are due to constrain global supply, and without additional production to offset the decline, the cost of crude is expected to climb.
The active crude oil futures contract was trading at a little above US$72.10 intraday Friday, in spitting distance of its 52-week high of US$72.28 set on Tuesday. Crude has risen almost 44% since its 52-week low in October 2017.
Moody’s Investors Service analyst Joy Rankothge said that higher oil prices and interest rates will place pressure on India’s fiscal budget and current account. However, growth prospects remain in line with the economy's potential — around 7.5% this year and next.
Rankothge added that this "robust growth, large foreign exchange reserves, a predominantly domestic funding base, strengthened monetary policy management, and macroprudential regulations on bank lending in foreign currency will broadly contain the credit impact of the higher oil prices and rising interest rates.”
Moody’s has assigned an investment-grade ‘Baa2’ sovereign credit rating on India.
Meanwhile, to date in 2018, the USD has appreciated around 14.4% against the INR, and certain of the country’s major aluminum and steel companies’ stocks has been suffering under the weight of U.S.-imposed tariffs.
While shares of TataSteel (TATASTEEL) have more or less moved sideways over the past few months, Visa Steel’s (VISASTEEL) stock has taken a nosedive. The company has also recorded a loss in the three months ended June 30th due in part to non-availability of working capital for its operations.
Overall, strategists at Pimco warned that “key political events are likely to keep investors cautious.”
Pimco added that while EM is “catching up to the recovery in developed markets, with improving fundamentals and greater differentiation among countries,” the recovery is likely to be “shallower and slower than others,” with a deteriorating external backdrop that could weigh on the asset class.
Although the Australian dollar (AUD) has rebounded somewhat against the USD ahead of the RBA’s cash decision Tuesday, it has weakened versus the greenback by about 10.6% since its 52-week high set in late January.
The RBA had kept its rate unchanged at 1.50% since it was lowered by 25bps in August 2016, as the country contends with low levels of inflation and higher-than-wanted unemployment.
RBA governor Philip Lowe also said high levels of household debt and slow income growth remain an overhang, with the country’s recent drought having led to challenging conditions in parts of the farming sector.
Additionally, Australia's terms of trade have increased over the past couple of years due to rises in some commodity prices. While the terms of trade are expected to decline over time, they are likely to stay at a relatively high level.
Governor Lowe added that the AUD remains within the range that it has been in over the past two years on a trade-weighted basis, but it has depreciated against the USD, along with most other currencies.
The RBA’s decision will be followed on Wednesday by Australia’s trade balance for August.
Further potential adverse impacts from tariffs, geopolitical flare ups, a decline in metals prices, such as iron ore, or a dip in demand from Australia’s trading partners – namely China – could each pose its own downside risks to the AUD.
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