EMFX: Carry and Domestic Fundamentals Rather Than the USD
Bottom Line: Most major EMFX currencies have performed better than the Euro or the Japanese Yen against the USD in 2024 (Figure 1). This is due to carry trades in Latam, but elsewhere reflects global equity love on Indian equities or domestic fundamentals. This resilience for Brazilian Real/India Rupee is set to be sustained for the remainder of 2024. Divergence with grow into Q2, with Turkish Lira losses set to accumulate on still wide inflation differentials and domestic vulnerabilities, the South Africa Rand volatile through the May 29 national and provincial elections and Mexican Peso vulnerable to a Donald Trump re-election in the U.S. We see more Yuan losses, given China economic weakness.
Figure 1: Movements Against the USD Since End 2023 (%)
Source: Bloomberg/Continuum Economics
Most major EM currencies have lost some ground against the USD this year, as the market has scaled back the scale of Fed easing expectations for 2024 (Figure 1). However, this is causing some softness, rather than material weakness for major EM currencies. The USD bounce versus DM currencies is certainly a factor impacting EM FX sentiment, but the key is carry trades and domestic fundamentals.
The Brazilian Real (BRL) and Mexican Peso (MXN) have held up reasonable, despite the Brazilian central bank easing cycle (here) and growing anticipation that Banxico could ease before the Fed (here). Interest rate differentials are still sufficiently in favour of these currencies (Figure 2), that too large a dip in these currencies prompts carry trade buying. BRL and MXN also benefit from a high level stability, with the Mexican election this year not expected to produce no major policy shifts (here) and President Lula in Brazil following a reasonable fiscal approach (here). MXN is also a beneficiary of production shifting away from China, and Mexico exports to the U.S. have now exceeded China. We see little movement in BRL and MXN spot by year-end, but the MXN alternative scenario of a Donald Trump re-election would produce Q4 MXN weakness.
Figure 2: 2yr Government Bond Yield Differentials Versus the U.S. (%)
Source: Continuum Economics
Other major EM currencies have less of favourable interest rate spread versus the USD and here domestic fundamentals and the India-China story are important. Inflows into India equities are a reflection of India healthy growth story (here), which is expected to be reinforced by a victory for PM Modi and leading to new reforms. This is the reason why the Indian Rupee (INR) has held up so well against the USD – the Reserve Bank of India (RBI) has actually had to buy USDs. Additionally, global investors pessimism towards China growth and equities is also pushing investors to look at other countries, with India top of the list. Our end year forecast of 83.00 on USDINR reflects expectations of ongoing inflows offsetting higher inflation that the U.S.
The CNY has not fallen too far against the USD however despite the economic pessimism and adverse interest rate differentials, both due to capital controls and also the perception that China authorities will fight too much Yuan weakness (here). Given economic weakness we still feel that some more exchange rate flexibility will likely be seen in the remainder of 2024, and our end of year forecast remains at 7.30 on USDCNY.
EMEA is a reflection of domestic fundamentals. TRY has seen less of a decline than the inflation differentials versus the U.S., due to the aggressive Turkish central bank tightening in 2023. However, domestic industry is pushing for a more competitive TRY and we still forecast high inflation in 2024 (42.5%). We see continued losses for TRY in 2024 as imports are stronger than exports, and foreign capital inflows remain weaker than expected. We look for 37.50 on USDTRY by end 2024. Meanwhile, the South African Rand (ZAR) has remained on the defensive despite reasonable interest rate differentials versus the U.S., especially in the 10yr area. Global investors want to see the outcome of the 2024 elections on May 29. An ANC victory would be a positive surprise for the ZAR, but an ANC coalition with the Democratic Alliance and other smaller parties would likely be weaker and less able to undertake necessary fiscal reform policies and deal with power cuts (load shedding) – especially of the radical Economic Freedom Fighters poll over 15%. The ZAR volatility will likely go up in Q2 depending on opinion polls and changes in market expectations on the two main election scenarios.