Unlock Editor’s Digest for free
FT editor Roula Khalaf selects her favourite stories in this weekly newsletter.
Emerging market currencies are heading for their worst first half since 2020. The unexpectedly strong dollar and the move away from a popular trading strategy in Latin American markets are driving their downward trend.
JPMorgan’s emerging markets currency index has fallen 4.4 percent so far this year, a decline more than double the same period over the previous three years. The decline came as investors gave up hopes of rapid U.S. rate cuts in 2024 and nervousness about weakening economies and expansionary fiscal policy pushed down currencies in some key emerging markets.
“It’s the combination of a more robust economy in the U.S. and on the emerging market side, where emerging markets like Chile, Hungary and Brazil have continued to cut their interest rates,” said Luis Costa, global head of emerging markets strategy at Citigroup.
“And let’s be honest: the growth prospects in emerging markets are not exactly great for this year and next. World trade continues to contract and it is a very complicated election year,” he added.
Much of the recent weakness has been due to the unwinding of so-called carry trades, in which investors profit from yield differentials between currencies, a trade that was popular with emerging market investors earlier this year.
But these deals have run into difficulties, particularly in the larger emerging markets, as asset prices have become more volatile following the elections and the future path of local interest rates has become more uncertain.
The recent weakness in the Mexican peso was “an example of the unwinding of a sizeable foreign exchange carry trade that had previously built up over two years, from mid-2022 to the end of May 2024,” JPMorgan analysts said this week.
The Mexican peso has fallen nearly 10 percent since the ruling Morena party won a landslide victory that stoked concerns about Mexico’s fiscal policy and led to increased intervention in the economy. Investors say the impact has also spread to other Latin American currencies such as the Colombian peso and the Brazilian real.
“The Latin American foreign exchange market has been largely responsible for the recent weakness – triggered by some political changes, but there has also been very strong positioning in some of the higher carry currencies, which has led to the unwinding of all trade,” said Grant Webster, portfolio manager at fund firm Ninety One.
Some investors have shifted their carry trades from larger markets such as Brazil to smaller, poorer economies that have just emerged from a turbulent period and where they believe policies including high interest rates still make bets on local currency bonds attractive, such as Nigeria and Egypt.
The Asian currencies most affected by the weakness of the Chinese economy have also struggled this year. The South Korean won lost seven percent against the dollar, while the Thai baht and the Indonesian rupiah each fell by around 6.5 percent.
Currencies around the world have struggled this year against the dollar, which rose 4.5 percent against a basket of six major currencies after strong U.S. economic data and stubborn inflation forced a major rethink on the interest rate outlook.
Investors are now betting that the US Federal Reserve will cut interest rates to two this year, down from six or seven at the beginning of the year.
“Just over half of the weakness in emerging markets is due to dollar strength,” said Kieran Curtis, emerging markets portfolio manager at Abrdn. “At the start of the year, investors thought there could be six or seven [US] interest rate cuts this year – and now there might not be any at all.”