With high interest rates and inflation easing, emerging economies are drawing a fresh influx of investment in their own local currencies.
Shaking off inflation, local currencies are strengthening against the dollar, with Mexico’s peso and the Brazilian real up 10 percent since 1 January.
This year through April, investors took $2.65 billion out of funds holding mainly dollar-denominated assets and put $5.23 billion into bond funds using local currencies, according to data service EPFR Global.
That influx has helped JPMorgan’s index of local-currency bond funds return 6.8 percent this year, compared to a 1.9-percent yield from hard-currency funds, which mostly are denominated in dollars.
“There is a strong consensus to be short the dollar on the basis of the [U.S. Federal Reserve] having reached the end of its tightening cycle,” Manik Narain, UBS’s chief emerging market strategist, said in an FT interview.
Fed chair Jerome Powell has indicated that the central bank may not lift its key rate again when it meets in June.
Last week, markets were pricing in a Fed rate cut of about 0.7 percent this year, despite Fed officials consistently insisting they will not cut rates before 2024.
The dollar was king while interest rates were rising. If they stop going up, or begin to fall, investors will look elsewhere for growth in the bond market.
“With the Fed on pause, that should lower interest rate volatility and create some room for investors to earn the risk premium in specific, higher-yielding emerging-market foreign exchange,” Kamakshya Trevedi, chief of foreign exchange and emerging markets at Goldman Sachs told the FT.
One reason: central banks in many emerging nations, such as Brazil and Mexico, began raising interest rates sooner than the U.S. Federal Reserve or European Central Bank did, allowing them to bring inflation under control sooner.
For example, Brazil’s central bank raised its base rate to 13.75 percent and has held it there since August 2022, which has helped to cut inflation to 4.15 percent in April.
In Mexico last month, the central bank boosted its policy rate again, lifting it to 11.25 percent while inflation slowed to 5.3 percent.
Double-digit interest rates guarantee a solid return beyond inflation.
Investments in emerging economies’ locally-denominated bonds “will accelerate when there is more confidence in the beginning of the Fed’s cutting cycle,” David Hauner, emerging markets strategist at Bank of America Global Research, said to the FT.
“Everyone is waiting for that green light,” he added.
TREND FORECAST: The dollar will continue to die a slow death as the world’s king currency.
The trend has shown itself in central banks de-emphasizing dollars in their reserves and shifting more toward gold and other currencies, as we noted in “Central Banks Shrink Their Dollar Reserves” (13 Apr 2021).
The trend is even more clear as an increasing number of countries are beginning to trade with China directly in yuan instead of going through the process of converting payments into and back out of dollars as a standard of value. (See “China’s Renminbi Doubles Its Share of World Trade Payments” and “Brazil’s President Urges Developing Nations to Dump the Dollar,” both in our 18 April 2023 edition.)
In years ahead, as oil declines in importance as the chief global fuel source, the dollar will tumble as more nations buy and sell oil in their local currencies.