Following Germany's top court approval of the new EU rescue fund, the euro is on the rise. Will emerging market currencies follow suit?
The single currency is back from the brink. Relieved by the news that Germany's constitutional court will allow Berlin to ratify the European Stability Mechanism, traders have pushed the euro to a fresh four-months high. Along with the European Central Bank's new plans to buy unlimited amounts of eurozone government bonds, unveiled last week, the much-awaited decision will go some way to convince market participants that tensions are past their peak.
Will it also benefit Emerging Market currencies? In the short term, most probably. EM currencies typically strengthen when the 'risk-on' trade is back, that is when a perceived improvement in macro conditions induces investors to bet on riskier assets. Since traders' anxiety over worsening eurozone woes had decimated EM currencies earlier this year, with Brazil's real at its weakest since July 2009 and India's rupee at an all-time low, the vision of a more collaborative Germany can only help reverse the trend. It also looks like today's Dutch election will not bring a Eurosceptic party to power, removing another Damocles sword over Brussels' efforts to solve the crisis.
EM currency bulls may also find reasons to rejoice elsewhere in the world. Weak job figures in the US, and an encouraging speech from Fed chairman Ben Bernanke last week, have reinforced expectations that the American central bank will launch a third round of quantitative easing. Earlier waves of QEs have played their part in lifting EM currencies to historic highs against the dollar over the past two years. China's premier has also announced that it had the room to do more to boost growth in the world's second biggest economy, raising expectations that further monetary and fiscal stimulus is on the way. This could prop up currencies in commodity-rich developing countries, and further prevent the global economy from petering out.
The rally may not benefit everyone the same, however. A basket of currencies are set to benefit: Brazil's real, Chile's peso, Russia's rouble, and China's Renminbi could do well. Some of them could even start flying, with analysts pointing out that, by and large, currencies have lagged the rally in stocks and rates. But currencies used in typically 'defensive' strategies - like the Turkish lira or the Mexican peso - could well lose out. August outperformers, such as the Polish zloty, the Hungarian Forint, or the Romanian Leu, may also struggle to sustain their rise; others could remain discounted due to resilient political uncertainty - the South African rand - or sluggish economic performance - the Indian rupee.
Nor is the rally guaranteed to last. The ECB's last move is bold by any standard - but remains dependent on ever tougher fiscal and economic reforms being imposed, and implemented, in European 'peripheral' states. The German court decision is also subject to conditions. Eurozone Banking reforms, for now in the background, are sure to go through a phase of fraught negotiations between EU member states. More bad figures could come from China. And America is still hanging over a threatening fiscal cliff, with Moody, the rating agency, warning that the country could face a downgrade if looming budget negotiations fail to deliver a satisfying compromise.
None of the EM currencies face the prospect of disintegration. But their fortune will remain closely tied to that of the euro, the US, and the world economy for the foreseeable future.