The diverging fortunes of bonds and currencies in emerging markets
As investors continue to fret over the embattled euro zone and gloomy US data, they stash their cash in ‘safe havens’. It’s been the Swiss franc, the Japanese yen, gold bullion. But also, increasingly, emerging markets bonds. Equities do badly (they suffer from the worsening economic outlook, like everywhere else) but local currency bonds are deemed a good bet, because they reflect the sound fundamentals of fast-growing economies. And so do these nations’ currencies, you would think.
Well, you would be wrong. As of Friday, an equally weighted basket of 23 EM currencies had lost all of this year’s gains, when some of them were up 10-15 per cent as recently as last June. So why is that?
External factors play their part. Currencies most exposed to wobbly markets (Western Europe) are being contaminated by investor’s fear over economic, fiscal, financial, banking uncertainties weighting on these region.
But domestic factors seem to play the bigger role. There are a lot of them, and all of the following have influenced each of the EM currencies’ fortune: fiscal balance, public debt, current account, commodity prices. Over the past week, however, one as clearly come to the fore. The perceived risk of a loosening fiscal and monetary policy, and behind this, EM’s weakening resolve to combat inflation, has emerged has a black spot in a so far sexy picture.
The case study here is Brazil. It surprised everyone by cutting its interest rate last week, despite stubbornly high inflation. Other central banks seem to go down the same route, either by enacting similar cuts or delaying expected rises. Analysts now wonder whether they’ve given up fighting inflation, in favour of a weaker currency and faster growth. And delay necessary adjustments, on the back of weaker global growth. Investors don’t like it, and sell their currencies.
So EM bonds, and currencies, look like they’re ‘decoupling’. Bonds are currently perceived as less risky than, say, the Greek or Portuguese one; yet they offer yields still hard to find on sounder markets. So they’re likely to remain attractive for a while. Currencies, on the other hand, increasingly factor in unchecked, entrenched inflation - and remain a risky asset.