The Fed Dulls Hopes of an Emerging Market Rebound

The dollar’s rally means emerging-market pressures are set to stick around

By Richard Barley

The rally in the dollar turned a winning emerging market trade into a loser

Emerging markets have swung from investor darling to disappointment this quarter. Any bet on a rebound will require patience.

One big stumbling block is the strengthening dollar. This week’s decisions by the Federal Reserve and the European Central Bank have dented hopes that the greenback might start weakening again. The contrast between the ECB’s caution on rates and the Fed’s confidence is stark.

A weaker greenback not only mathematically increases local-currency returns; it also boosts investment flows to poorer countries, which helps to brighten the growth outlook.

Exchange Rates against the U.S. Dollar

When the dollar rises, as it has since April, this mechanism goes into reverse. With signs that the U.S. economy is outperforming, the latest move has been sharp: The ICE dollar index has climbed 6.3% in just two months.

Moreover, there is little sign that the weak links exposed by the dollar’s rise are out of the woods. The Argentine peso and the Turkish lira are still under pressure, even with Argentina signing up for a $50 billion International Monetary Fund package and Turkey belatedly raising interest rates sharply.

Argentines protested after the IMF welcomed the government's austerity measures. Photo: Sarah Pabst/Bloomberg News 

The initial hope was that these fault lines might not spread. After all, many other nations have increased their resilience by reducing economic imbalances. But now further problems have arisen.

The Brazilian real has fallen 13% against the dollar so far in 2018. Tax concessions made by the government to end a truckers’ strike in May have raised concerns about its failure to reform Brazil’s pension system, on which the IMF says spending is unsustainable. With an election due in October, this worry will remain live.

One consolation is that emerging-market assets and currencies are cheaper. The yield on the JPMorgan index of local-currency bonds has risen half a percentage point this year to over 6.6%. The gap between the yield on dollar emerging-market bonds and Treasurys has expanded to 3.5 percentage points. In a world still hungry for yield, that might sound attractive.

However, it is probably too early to turn bullish. Markets require a catalyst to change direction. In the absence of a weaker dollar to grease the wheels, that requires fundamental improvement. The best hope might be that growth outside the U.S. stages a rebound, but that will take time to show up in the data.

Emerging-market bonds and currencies may be cheaper, but the headwinds to a rebound have built too.

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