EM Relief from Peak Fed Rates?
Hopes that Fed interest rate hikes could be finished before the end of 2022 are starting to prompt questions about whether EM central banks and financial markets will get some relief. What are the prospects?
Bottom line: When Fed Funds eventually peaks, it should provide some relief for EM countries via less upward pressure on the USD — especially with the USD overvalued and with wide bond spreads in Brazil and South Africa. However, global commodity prices and the domestic inflation fight are the key issues for large EM policy. With more labor market slack than the U.S., large EM can navigate a more gradual course of interest rate hikes and in Brazil and Mexico shift toward an easing cycle in 2023.
Figure 1: USD Real Effective Exchange Rate (2010 = 100)
Source: Datastream, Continuum Economics
Fed Peaking and EM FX and Bond Yields
Financial markets are now discounting that the Fed will finish tightening by the December FOMC meeting, and our June Outlook (here) highlighted the view that we will see a 50bp hike in September and then a final hike in November. What are the prospect for EM FX and government bond yields and central bank policy in EM countries?
- USD Index overvalued: We would highlight that the USD is overvalued, which in evident in real exchange rate measures (Figure 1) and also the deterioration in the U.S. current account deficit. This overvaluation has echoes of the end of Fed tightening in May 2000, in contrast to the undervalued USD that existed at the end of the Fed tightening cycle in June 2006. The overvaluation benefit to EM countries' competitiveness is also being diluted by the USD being the dominant global currency for goods, which reduces pass-through benefits to export industries. The 2018 end of the Fed tightening cycle in December was followed by modest FX movements rather than a big trend move. Once U.S. interest rates peaked in May 2000, the market shifted to hopes of rate cuts and this prompted a clear decline in the USD over the 2000s. We feel that the big picture is for the USD to decline in H2 2022 and 2023 vs. DM currencies as highlighted in the June FX outlook (here), with the geopolitical and economic backdrop differing from 2000. This will be a factor across EM currencies as well, though the domestic economic, policy and politics will be the most important drivers.
- After the end of the 2000 Fed cycle, EMs mostly rose. Figure 2 shows key EM currency movements against the USD in the three months before Fed Funds peaked and the three months afterward. After May 2000, EM currencies saw modest gains except for the Indian rupee. The narrative in 2000 was overall an EM-positive one. With China due to join the WTO and welcoming foreign investment, fund flows to EM as an asset class strengthened. This was further supported by recovery and reform programs implemented in Russia and Turkey. Although valuations and a relief from a Fed peak still offer opportunities, this time around investors will be facing a less friendly narrative in some major emerging markets and also a deglobalization trend. Interestingly, though the USD REER did not fall much after the December 2018 peak, EM currencies gained ground against the USD (except the South African rand). Certainly the market bias is for EM currencies to gain some ground after a Fed Funds peak, though we would place greater weight on the current economic/inflation conditions and policy stance.
Figure 2: USD Mixed Performance vs. Key EM Currencies as Fed Funds Peaks (%)
Source: Continuum Economics (positive is USD appreciation and negative is USD depreciation).
- Government bond yield spreads wide: Brazil and South Africa 10yr government bond yield spreads are wider than the approach to the Fed peak in 2018 (Figure 3), and Brazil, Mexico and South Africa are also wider than the June 2013 taper tantrum — India is similar to 2013 and China narrower. This is in part a reflection of domestic monetary policy stances (see below), which have been more aggressive than the Fed in Brazil and Mexico, as well as commodity price benefits to exports. This has helped the Brazilian real appreciate against the USD YTD, Mexican peso to be flat and South African rand to fall only 3.5%. In contrast, the euro has fallen 10% vs. the USD. Even the Chinese yuan and Indian rupee have seen cross rate gains vs. the DM majors this year. China has undertaken a controlled depreciation to avoid excess volatility causing capital flight, but this has still allowed China to trim interest rates, which has helped to produce a clear spread narrowing vs. U.S. 10yr yields — domestic players dominate the government bond market and do not readily switch to Treasuries. Indeed, China's official holdings of U.S. Treasuries have been reduced this year due to reserve diversification (here). India wants to avoid excess depreciation vs. the USD, as this could boost inflation expectations, and this has prompted FX intervention (here) by the Reserve Bank of India (RBI) in the face of portfolio outflows caused by the adverse global risk environment. Some RBI tightening has been seen, but the RBI is trying to steer a different pace of tightening compared to the Fed. As we previously highlighted (here), key EM countries have plenty of slack in the labor market (Figure 4) and this reduces the risk of second-round wage/price spirals — though Mexico has a low official unemployment rate, the informal sector is large and acts as a buffer to labor market tightness. Moderate wage indexation means that the risk of EM pass-through remains, and this is a question of country-by-country and policy reaction functions (see below).
Figure 3: 10yr EM Government Bond Spreads vs. U.S. (%)
Source: Continuum Economics
Figure 4: Key EM Unemployment Rate (%)
Source: Continuum Economics
- Undervalued currency and high bond yields: It also worth reflecting on combined risk premia in the FX and government bond market. Sometimes currency undervaluations reflect a deliberate domestic independent monetary policy that is different from the Fed, and China is probably closest to this example. However, sometimes the currency is undervalued in real terms and nominal bond spreads are also wider than normal. Provided an EM major can get inflation back toward target, then this dual risk premia becomes too large and provides an excessive buffer. For Brazil this has been the case and is one of the reasons behind the move to a less undervalued Brazilian real this year — fair value is around 4.60 on USD/BRL. In assessing external risk premia, currency, government bond yields and to a degree equity markets need to be looked at on a combined basis, rather than individually.
- EM vs. the U.S.: Major EM countries mostly did not overstimulate like the U.S. during the COVID crisis, which means that domestically generated inflation pressures were not created on the same scale as the U.S. by policy alone. However, the global energy crisis and then the Ukraine war have prompted a surge in global energy and food prices, where food is a greater proportion of CPI baskets than the U.S. or DM countries. This has elevated headline CPI and prompted some spillover into core inflation (Figure 5).
Figure 5: Key EM and U.S. Core CPI Inflation (%)
Source: Datastream, Continuum Economics
- Policy reaction function: Our economists would also note that interest rate forecasts are influenced by policy reaction functions, which have evolved over the past 20 years with changing structure of economies and adoption of best central bank practice in certain countries (e.g. minutes, inflation reports, inflation targeting and independence in certain cases). Brazil and Mexico made the choice to move ahead of the Fed (Figure 6), and wide short-term interest rate differentials allow policy flexibility independent of the Fed into 2023. EM financial conditions ex China are also tighter (Figure 7).
Figure 6: Key EM Policy Rates and U.S. Fed Funds 2018-22 (%)
Source: Datastream, Continuum Economics
Figure 7: EM Financial Conditions (%)
Source: IMF
China: China's policy rate is expected to be relatively flat, with a mere 20bp cut in the 7-day reverse repo rate toward end-2022 and into 2023, as the Chinese economy is recovering from the COVID lockdown during March-May 2022. We view the coming stimulus effort to support the economy as being tilted more toward the fiscal side of things rather than monetary easing. As the lack of loan and investment demand is at the core of the economic problem, rate cuts, which focus on reducing funding costs and releasing funding supply, will be insufficient to boost economic growth in coming months. Rather than cutting funding costs and waiting passively for enterprises to borrow, fiscal stimulus can directly boost credit and loan growth and government spending. We also project such fiscal stimulus to be augmented in the sense that it can go beyond central and local government spending and be channelled through state-owned enterprises (SOEs). We expect relevant discount and encouragement policies to be in place such that SOEs will take the place of private enterprises in terms of leading the investment plans and supporting loan demand. In the face of the shift in policy focus from monetary easing to fiscal stimulus, monetary policy divergence between China and the U.S. will narrow but is still present, with the U.S. tightening while China leans slightly toward small cuts.
India: After the 50bp Aug. 5 hike to 5.40%, the RBI is signaling that it will follow through, and we look for a further 40bp hike to 5.80%. Current inflation is a concern in that it could feed into inflation expectations. However, the reduction in oil, food and other commodity prices over the past two months should provide some relief for the monthly CPI numbers in July and August. Hence our more measured 40bps, rather than a repeat of the 50bps seen in August. Indeed, we see the RBI repo rate at 5.8% by end-2022, both as we only have meetings in September and December and as the RBI objective is to get to the neutral rate range of around 6% and then review the economic and inflation trajectory into 2023. If the Fed slows tightening, it will also reduce pressure on the Indian rupee.
South Africa: The South African Reserve Bank (SARB) has been delivering a front-loaded tightening since November 2021. As the policy rate has reached 5.5% as of July 2022, the tightening cycle, driven by inflation that exceeded the SARB's target of 6% in mid-2022 and global monetary policy tightening, has likely come to an end. The SARB's front-loaded approach has kept inflation expectations under control. Along with easing commodity prices in 2023, we forecast South African inflation to slow and fall below the 6% target by mid-2023. The SARB's most recent projections point to the continuation of the tightening cycle next year, with the repo rate reaching 6.45% by the end of 2023. We forecast that with Fed rates peaking by the end of this year and elections coming up in 2024, this hawkish signaling will not be realized. On the back of alleviating external factors over inflation and the government's target of creating jobs, the SARB will keep the policy rate at its current level throughout 2023. This is a small view change relative to our June Outlook view of a peak of 5.75% in 2023.
Brazil: The Brazilian Central Bank (BCB) was one of the first to start raising interest rates (SELIC), due to a strong devaluation of the real and the rain shortages that increased electricity prices, which started to feed the inflation dynamic by January 2021. After multiple hikes, bringing the SELIC to 13.75% from 2.00%, the BCB might not have finished its hiking cycle as inflation has been persistent and 2024 inflation projections are not aligned with the BCB target. We believe that the BCB could apply a final rate hike in September, but more importantly then will keep the interest rate at a high level until inflation comes down and expectations are realigned with the BCB target. Interest rate cuts are set to occur only when inflation has severely dropped during H2 2023. A rate cutting cycle should then begin, to extend into 2024. We see the SELIC at 10.50% by end-2023 and most of this movement shall be dominated by domestic data and quite independent from Fed moves.
Mexico: Normally the Mexican central bank (Banxico) is vigilant to all Fed moves, since capital flows from U.S. to Mexico are of utmost importance for the Mexican economy. However, Banxico moved faster and more aggressively than the Fed to start raising interest rates, which has meant that the peso has held up quite well vs. the USD and appreciated against most other currencies. The MXN is thus secondary to the domestic inflation problem. We foresee Banxico applying new hikes in August (75bps), September (50bps) and a final 25bp hike in November to 9.25%. Banxico will likely then keep interest rate steady at a restrictive level to help inflation come back down toward its target range. With fiscal policy remaining disciplined, it is possible that the economy enters into contractionary levels in 2023, leaving a possibility for Banxico to start cutting rates by the second half of 2023, which could be extended up to early 2024. This is a small view change relative to our June Outlook view of a peak of 9.0% and rate cuts starting in Q2 2023.