Emerging markets at risk of higher US yields

Rising UST rates are having a near term effect on currency markets, particularly among emerging market FX rates. Our outlook for FX in general in 2021 is growth rather than rates dependent which should support the outlook for EM FX in principle. However, the sharp steepening of the UST curve and a fitful start to Covid-19 vaccination campaigns in emerging markets means there is a risk of EM FX pulling back sharply against the dollar.

Wide differentials to US dollar rates along with relative economic outperformance in 2020 compared with developed markets meant major emerging market FX rates bounced back strongly from a Q2 sell-off, albeit with some notable exceptions. Growth in emerging markets is poised to outperform developed markets this year and the recovery will be more widespread than in 2020 when China was the only major economy to record expansion. Better economic performance in India and across South-East Asia in particular should help to push EM growth rates higher.

However, deployment of Covid-19 vaccines has begun at a slow pace across many emerging markets. Several are only just beginning and likely won’t deliver first doses to the majority of their populations until well into the second half of 2021. Prolonged interruption to pre-pandemic levels of economic activity—particularly the closure of tourism sectors upon which many emerging markets are reliant upon as a source of FX inflows—will weigh on growth outlooks even if control over Covid-19 infection levels looks plausible in the medium term.

Past periods of steepening saw sell offs in EM

Given the highly trade-dependent structure of many emerging market economies the reflation trade should notionally be supportive for growth and FX rates. Investors seeking yield and high commodity prices both feed into a positive story for EM FX. In the short-term, however, the steepening of the UST curve presents a clear and present risk for EM FX.

Source: Bloomberg, Emirates NBD Research.

During past periods of UST curve steepening, many EM FX pairs weakened against the dollar as funds flowed toward the safety of UST despite wide nominal interest rate differentials in favour of EM currencies. The UST 2s10s curve has now broken above 120bps as policy from the Federal Reserve keeps short-term rates anchored at low levels and reflation expectations help to push 10yr UST yields higher.

Emerging market currencies resilient so far

So far EM FX has held reasonably steady with major pairs holding their year-to-date gains against the dollar. TRY has been a notable outperformer, gaining more than 6% against the USD so far this year while EGP is up 0.5%. A broader index of EM currencies weighted by nominal GDP levels is down slightly so far in 2021, however, as Latin America remains an area of relative underperformance along with mid-sized economies in Asia (South Korea, Indonesia and Malaysia in particular).

EM currency index - rebased 1yr

Source: Bloomberg, Emirates NBD Research. Note: rebased 1yr. Weighted by nominal GDP.

While yields remain attractive in many EM in both nominal and real terms, the risk of rising UST yields pulling funds out of EMs could result in a disorderly sell-off. Measured by their carry-to-vol ratios, TRY and INR both stand out as being at risk of a weakening move against the dollar while ZAR, MXN, RUB and IDR form a second tier of at-risk EM currencies.

EM yields vs FX volatility

Source: Bloomberg, Emirates NBD Research. Note: implied yields from forwards or NDFs where applicable.