'Dovish' US Interest Rate Hike Limits Downside in EM Foreign Exchange

Emerging market economies will be relieved after the US Federal Reserve delivered a 'dovish hike,' - a small interest rate rise that is unlikely to be followed by further agressive hikes.

In large part due to the forecasted weakening of the USD, following a dovish rate hike from the US Federal Reserve, EM currencies should have less to worry about, says HSBC Global Research.

The research team states,“Indeed, gradual tightening accompanied by low core bond volatility is an important factor that argues for our base case - that the pace of EM currency weakness should be slower in 2016.

“Within EM FX, our strongest preferences are those currencies with favourable valuations, reasonably high yield, and stronger prospects of a growth recovery. Admittedly these are far and few between.”...

Whilst some currencies can benefit from weakening, since it boosts exports, excessive weakness as has been witnessed in some EM currencies this year - such as the Brazilian Real, Turkish Lira and Colombian Peso - all of which have devalued more the 20% versus the dollar in 2015, can cause major challenges as they isolate the country making key imports unaffordable. 

Other Worries Remain For EM FX

Generally, high yielding EM currencies did not trade well in 2015 and pressures on these currencies cannot solely be attributed to the US Federal Reserve monetary policies.

In 2015, we have seen internal domestic factors plague EM currencies as economies of developed countries improved.

One of the most notable and recent examples is the South African rand, which has been battered by outflows to developed countries and domestic economic challenges; in five days, the country has had three finance ministers.

Another was the Russian Rouble which suffered after sanctions were intriduced following international outrage at the invasion of Crimea.  

Therefore, the extra weight these EM currencies would have felt from a more hawkish rate was reduced by the dovish tones of the Fed’s December monetary policy statement.

Asian Currencies to Weaken vs USD

HSBC Global Research also expects Asian currencies to weaken on the backdrop of the Fed’s rate liftoff, but not as sharp as in 2015.

Notably, HSBC expects INR (Indian Rupee) and IDR (Indonesian Rupiah) to outperform regionally saying,

“We see a more supportive environment for the higher yielding INR  and the IDR, reflecting our expectations for reforms and prudent macro policies in those two economies.

“The regional laggards should be TWD (Taiwan Dollar), PHP (Philipinese Pound) and MYR (Malaysian Ringgit) on respective negative local factors such as growth underperformance, political uncertainty and fiscal risks.

“The ‘middle kingdom’ is expected to include the KRW (South Korean Won), THB (Thailand Baht) and SGD (Singaporean Dollar). Among these, we believe the SGD will be slightly more resilient, given a relatively less dovish central bank.

“As for the RMB, notwithstanding a gradual Fed hike cycle, we expect it to weaken further amid greater two-way volatility, due to China's cyclical headwinds.”

Dovish Hike A Mixed Bag for CEEMEA

In broad terms, the Fed’s decision – a 25bps rate hike with further hikes gradual and contingent on economic improvement and hitting the 2% inflation target – have eased the downside pressures on most CEEMEA (Central and Eastern European, Middle Eastern and African) currencies.

HSBC Global Research expects currencies that have had a “significant adjustment in their valuations and/or where there has been a sizeable positioning reduction [to] outperform” such as the TRY (Turkey Lira).

For other CEEMEA currencies the team states,

“[The] RUB (Russian Rouble) will continue to struggle amid deep macro challenges and a very low oil price.

“[The] recent market turmoil in South Africa due to cabinet changes is likely to make the market cautious on ZAR.

“In CEE, we do not believe that the PLN (Polish Zloty) & HUF (Hungarian Forint) will be positively impacted in a lasting manner.A gradual tightening in the US and ongoing QE in Europe may see more loosening in Poland and Hungary. Therefore, we would not chase any potential currency strength.

“We believe that the best way to express a positive bias in the CEEMEA region would be to be long ILS (Israeli Shekel).

“As for [Latin America], the Fed’s more dovish bias should not see a large reaction from the region’s currencies.

“If the USD softens, this would likely translate best for the MXN. Mexico faces less domestic challenges and has suffered notable short-term weakness of late, making it attractive from a valuations perspective so long as oil prices do not continue their decline.

“The high yielding BRL (Brazilian Real) could also benefit if the dovish Fed bias leads to some unwinding of the market’s significant long USD-BRL positioning, but we would still expect the BRL to weaken over the medium term on domestic factors.

“Other currencies in the region could garner some near-term support from a dovish Fed, but we believe their fate primarily rests with the performance of commodity prices, notably oil and metals.”