Latin American FX has been surprisingly resilient on the back of good carry and strong commodities and has received a further boost from cautious central banks that started hiking rates earlier than in developed markets.
This was the view of JPMorgan analysts in a recent research note, but there are several reasons why this resilience could be sorely tested in the coming months. These include low expectations for significant appreciation against the dollar as commodities weaken and high inflation limiting real rates improvement.
COP has a large current account deficit and we expect political risk premia to remain high
Oliver Harvey, Deutsche Bank
Latin American central banks – which began battling inflation eight to 12 months ahead of the US Federal Reserve – have continued to hike policy rates to levels as high as 13.25% in Brazil and 9% in Chile during the first quarter. During this time the Chilean peso and the Colombian peso gained around 10% and the Brazilian real appreciated by approximately 19%, explains StoneX FX trader Daniel Socci.
“As the Federal Reserve commits in earnest to tackling inflation in the US, carry will begin to erode,” adds Socci. “Perhaps more importantly, worries that an overzealous Federal Reserve Open Market Committee may push the domestic economy into recession also weigh heavily upon emerging markets.”
Looming elections and political risks will also provide specific pressures for the Brazilian real and the Colombian peso. In Colombia, questions abound regarding the composition and disposition of the new government with fears that aggressive socialist policies may result in capital flight and local currency depreciation. Brazil faces a general election in October and the political build-up to this event – in conjunction with persistent inflationary fears – may similarly pressure the real this summer.
In both Latam and central and eastern Europe, Middle East and Africa (CEEMEA) valuations are cheap and foreign positioning is very light. Oliver Harvey, head of CEEMEA and Latam currency research at Deutsche Bank, notes that in the latter region the bank is most positive on MXN and BRL and most negative on COP. “COP has a large current account deficit and we expect political risk premia to remain high,” he adds.
Global growth pressures
Paul Mackel, global head of FX research at HSBC acknowledges that the relative outperformance of Latam currencies is an oddity given that the global growth pressures are skewed to the downside.
“Normally, these currencies do not perform well when global growth is slowing and as a result we are wary that some have stretched too far,” he says. “Nonetheless, there should be some pockets of long-term resilience for the BRL and MXN.”
The ECB and the Bank of Japan have struggled with the market, trying to raise short-term rates without triggering a rise in long-term rates
Alex Kuptsikevich, FxPro
Daniel Tenengauzer, head of markets strategy at BNY Mellon, agrees that the peso is vulnerable and also points to the Peruvian sol.
“We believe that Latam EM [emerging market] currencies can continue to prove more resilient than those in other regions, although we think investors could reduce exposure to Brazil’s real in favour of the Mexican peso,” he says. “Brazil’s central bank is nearing the end of its tightening cycle, in our view, whereas Banxico will likely be following the Federal Reserve’s rate hikes.”
Elsewhere in emerging markets, HSBC is positive on the SGD and sees the RMB being fairly stable in the months ahead. However, Mackel also notes that a number of emerging market currencies face a mix of slow growth and high inflation.
According to HSBC, central European currencies are in a tough spot and so too are some of the current account deficit currencies in Asia (including INR, PHP, IDR and even the THB) where BNY Mellon is bearish on the Philippine peso and China’s yuan.
FxPro senior market analyst Alex Kuptsikevich reckons Asian emerging markets could be the stars of the second half of 2022 on the back of lower inflation and strong growth in India and China. But for other emerging markets the situation may not be so positive.
“The ECB and the Bank of Japan have struggled with the market, trying to raise short-term rates without triggering a rise in long-term rates,” he says. “In a worst-case scenario, this could lead to a repeat of the debt crisis as with Greece a decade ago.”
The dollar leads the game and the emerging market currencies could only gain back ground if the dollar eases
Ipek Ozkardeskaya, Swissquote
FxPro is inclined to see markets returning to growth in the second half of the year based on the expectation that the period of maximum inflation acceleration will pass within the next couple of months or has already passed for some indicators. If so, the dollar will cease to be the darling of the markets and will move into retreat against most competitors.
However, serious issues remain to be addressed in Sri Lanka, where the currency has depreciated more than 80% since the first quarter, and Pakistan, whose currency is down around 20% over the same period.
According to Timothy Peng, head of trading, Asia Pacific, at StoneX, these countries face similar issues, namely negative FX reserve inflows, mounting Chinese debt repayments and political uncertainty.
Rising global inflation has encouraged a reverse currency war where instead of devaluing their currencies through easy monetary policies to boost the competitiveness of exports, central banks are obliged to tighten their policies to tame the impact of the strong dollar on inflation via imports.
“The dollar leads the game and the emerging market currencies could only gain back ground if the dollar eases; and for the dollar to ease, the Fed must soften its tone,” argues Ipek Ozkardeskaya, senior analyst at Swissquote. “For that to happen, we would need to see inflation fall significantly and persistently – and we are not there just yet.”
