Danger of 'sharp selloff' in emerging market currencies

When the Federal Reserve stops buying bonds and the dollar starts to rally, emerging market currencies are likely to sell off sharply, a strategist warns

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Speculation about when the Fed will stop its quantitative easing program has been increasing, with many analysts predicting that this may be closer than expected as US economic growth normalizes.

When that happens, the US Treasury curve will steepen and the dollar rally will rally mainly against currencies in the G10, but because there is such “heavy positioning” in emerging markets currencies, there is a risk of a “sharp selloff,” according to Patrick Legland, head of global research at Societe Generale.

In line with other economists’ predictions, the bank’s analysts expect the US dollar to outperform the UK’s pound sterling, Japan’s yen, the Australian dollar and other G10 currencies due to higher yields for US Treasuries and an improvement in the US national balance sheet.

Higher US Treasury yields will make it less attractive for US dollar investors to buy riskier assets at home and abroad, and those borrowing in US dollars will find that their funding costs rise, Legland wrote in a special research report under the headline “The Return of Yield.”

“The main risk as the back end of US Treasury yield rises is that the cost of US dollar funding for emerging market positions will force a correction leading to a brutal increase in EM/US dollar foreign exchange volatility. This is the main portfolio position globally and as such is very sensitive to a setback,” Legland said.

‘LARGE CORRECTION’ COMING

The large position in emerging market currencies versus the dollar is a side effect of global imbalances, with many emerging countries having built large dollar reserves as they were fighting against strengthening of their currencies which would have harmed their exports, he explained.

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Besides, US investors, put off by low yields in US Treasuries, sought more yield in developing countries, creating higher capital inflows in these markets which were then partially reinvested by their central banks into the safe-haven US Treasuries, creating “a self-sustained feedback loop.”

As this encouraged cheap funding, it boosted economic activity and sent export volumes higher, and these exports in their turn created more US dollar inflows into emerging economies; in terms of portfolio positions, Asia is exposed, while in Latin America Mexico is the most at risk, Legland said.

Traditional funding currencies such as the yen and the Swiss franc have seen sizeable moves, leading to a rebound in G10 foreign exchange volatility, he said.

“Emerging market foreign exchange volatility is yet to be moved from its ultra-low levels and is consequently at risk of a large correction in the coming months,” Legland added.

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