By Gertrude Chavez-Dreyfuss
NEW YORK (Reuters) – Investors are grappling with conflicting signals on emerging market currencies as they weigh easing by the Federal Reserve and other major central banks against the economic damage already wrought by the coronavirus outbreak.
The MSCI International Emerging Market Currency Index pared a portion of its 2020 losses in recent days as the Fed, Bank of Australia and other developed-country central banks unleashed rate cuts aimed at cushioning their economies from coronavirus-fueled slowdowns. The measure is still down more than 2% on the year.
(GRAPHIC: MSCI International EM Currency Index – https://fingfx.thomsonreuters.com/gfx/mkt/13/2903/2868/MSC1%20EM%20%20Index.png)
Emerging market bulls typically welcome lower rates in the developed world as they boost the attractiveness of developing countries’ assets and help fuel the carry trade, a strategy in which investors borrow in low-yielding currencies to invest in higher-yielding ones.
Some are concerned that it may be too early to bet on the battered asset class, with the coronavirus outbreak threatening to weigh on growth in the United States and Europe as it accelerates outside of China.
Data from the Institute of International Finance showed that February portfolio flows to emerging markets were down nearly 90% from the previous month, at $3.4 billion, illustrating how investors soured on the boom-or-bust asset class as fears grew over the coronavirus outbreak.
Returns on carry trade strategies, meanwhile, are down 2% since January 31 after notching a 6.1% gain in 2019, according to an index from Credit Suisse measuring returns on 15 emerging market currencies. Few may be willing to jump back into the strategy if uncertainty over the coronavirus continues to shadow global growth.
“You’re getting a little more carry in emerging markets … but there is so much uncertainty about the impact of the virus on growth that people won’t want to be long risky currencies,” said Momtchil Pojarliev, head of currencies at BNP Asset Management. “It’s just not a good place to be.”
The asset manager exited bets on emerging markets before the coronavirus outbreak gained momentum and is now betting on the U.S. dollar and Japanese yen to rise against other currencies.
Some of the declines in emerging market currencies have been dramatic, rivaling recent drops in the S&P 500 and other stock markets. The Brazilian real – the world’s worst-performing traded currency year-to-date – has fallen more than 13% this year, with the Chilean peso and South African rand not far behind. All three nations, like many other emerging market economies, count China as one of the top destinations for their commodity exports.
“We’re obviously concerned that… we’re headed toward recession,” said Emily Weis, emerging market strategist at State Street in Boston. “Carry (trades) certainly won’t be my favorite play in a risk-off environment.”
Investors in emerging market currencies may also face the risk that the central banks of developing countries will embark on their own rate cuts as they try to shield their economies from a potential global slowdown. That could weigh on their currencies by narrowing the gap in yields between assets in emerging markets and those in developed ones.
Edward Glossop, emerging markets economist at Capital Economics in London, said he expects central banks in much of emerging Asia to continue cutting interest rates. He anticipates additional rate reductions in Brazil, India, Mexico, Poland and South Africa.
Bank Negara Malaysia already reduced its policy rate by 25 basis points to 2.5% in March, bringing cumulative easing this year to half a percentage point.
The Reserve Bank of India earlier in the week said it, too, is ready to take appropriate action with respect to the coronavirus and analysts said one of those actions may include a rate cut.
(Reporting by Gertrude Chavez-Dreyfuss; Editing Ira Iosebashvili and Dan Grebler)