Analysts at BofA Securities have pointed out that Emerging Market (EM) foreign exchange (FX) is poised to perform better in a potential hard landing scenario compared to previous similar episodes. This positive outlook is attributed to key shifts in the factors influencing EM FX since the onset of the COVID-19 pandemic.
One of the major factors driving this optimism is the potential support from lower oil prices and easing U.S. monetary policy. Analysts at BofA have identified three main drivers of EM FX performance post-COVID: U.S. terms of trade (ToT), the U.S. 2-year swap rate, and China’s house prices. This marks a departure from the pre-COVID period when factors like global growth and commodity prices had a bigger impact on EM currencies.
The correlation between U.S. terms of trade and oil prices has strengthened significantly since the pandemic, reflecting the United States’ role as a major oil exporter. Additionally, the importance of U.S. monetary policy, particularly the 2-year swap rate, has increased in driving EM FX. A decline in the 2-year swap rate, resulting from Federal Reserve easing in response to a hard landing, is expected to provide support to EM currencies.
China’s housing market has also emerged as a significant factor for EM FX, with fluctuations in China’s house prices closely tied to the performance of EM currencies. In the event of a hard landing, where there is a sharp economic slowdown, both oil prices and the U.S. 2-year swap rate are expected to fall, potentially supporting EM FX.
However, analysts caution that in the event of a major credit event, such as a financial crisis, traditional risk-off sentiment could dominate, leading to a weakening of EM FX despite the potential support from lower oil prices and U.S. monetary easing.
BofA’s Principal Component Analysis (PCA) of EM FX indicates that global growth has become less important for EM currencies post-COVID. U.S. interest rates, the DXY, and market volatility have become more significant drivers of EM FX, while traditional indicators like EM export volumes have lost their previous significance.
Overall, the future of EM FX in a potential hard landing scenario looks promising, with lower oil prices, easing U.S. monetary policy, and shifts in key drivers expected to support EM currencies.
Analysis: In simple terms, the article discusses how Emerging Market foreign exchange is expected to perform well in a potential economic slowdown due to factors like lower oil prices and U.S. monetary easing. The key drivers of EM FX have shifted post-COVID, with factors like U.S. terms of trade, the 2-year swap rate, and China’s house prices playing a more significant role. While there are positive projections for EM FX in a hard landing scenario, caution is advised in the event of a major credit event. Overall, understanding these factors can help individuals make informed decisions about their finances and investments.