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Bears Rule Emerging Markets as Central Banks Battle New Variant

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(Bloomberg) — If emerging market central banks were having a tough time shoring up their currencies as the Federal Reserve steps up its scaling back of monetary stimulus, their task just got a whole lot harder.

Worries over the emergence of the omicron Covid-19 variant sent risk assets into a tailspin Friday, tipping MSCI Inc.’s gauge of developing-world currencies into deficit for the year and potentially on track for its first annual decline in three years.

Central banks in the developing world were being enfeebled by the dollar’s renewed vigor long before omicron was identified, with policy tightening from South Korea to Russia and Brazil doing little to stem the currency losses that are fueling inflation. The biggest losers this month are Mexico’s peso, South Africa’s rand and Hungary’s forint, all currencies from countries that have lifted interest rates in November. That’s put bearish investors in the ascendant.

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“Any factors which limit visibility makes life more difficult for central banks,” said Viktor Szabo, a senior investment manager at abrdn plc in London. “But an increasing number of emerging market central banks start to realize that the question of whether inflation is transitory or not is not really relevant at this stage. Inflation is high and sticky, even if caused mainly by supply-side shocks, and can de-anchor inflation expectations and put pressure on currencies.”

The threat of a more serious variant could also push key mature-market policy makers, such as the Fed and European Central Bank, to turn more dovish, which could balance out the need for more aggressive tightening in developing nations, said Olga Yangol, head of emerging-markets strategy at Credit Agricole SA in New York.

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“The variant may indeed hammer emerging markets harder than other assets, in particular high beta currencies in Latin America and South Asia that are more sensitive to risk sentiment and more exposed to energy and tourism, the sectors that get the most impacted by the pandemic,” she said.

‘Punished by Markets’

Political meddling hasn’t helped. Turkish President Recep Tayyip Erdogan’s campaign for lower rates sent the lira into freefall last week. The Mexican peso slumped as President Andres Manuel Lopez Obrador’s nomination of a little-known finance ministry official to lead Banxico fueled concern about possible government interference in the central bank’s independence. 

“Any sign of government interference in monetary policy will be punished by markets immediately as long as global monetary headwinds are stiffening,” said Witold Bahrke, a Copenhagen-based senior macro strategist at Nordea Investment. “Although the primary reason for us to be underweight emerging-market currencies is tightening global monetary conditions, this is reinforcing the bearish case for the market.”

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The correlation of emerging-market currencies to short-term Treasuries is near the strongest level since 2014, underscoring the potential fallout from higher U.S. interest rates. Investors are hedging against the risk of wider price swings as the dollar climbed to the highest since July 2020. JPMorgan Chase & Co.’s gauge of implied volatility in developing currencies rose last week above 10% for the first time since April. 

Real rates — which strip out inflation — in most developing economies remain below zero, even after tightening. That’s dimming the appeal of emerging-market assets as U.S. yields rise and concern over the durability of the recovery in the developing economies deepens. Investors will get further clues on the health of emerging markets in the coming days, with China’s official purchasing manager indexes due for release and gross domestic product numbers scheduled from Turkey to India and Brazil.

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Policy Dilemma

Hungary, which had trailed central European peers Czech Republic and Poland on the policy-tightening path, delivered its third interest-rate increase in two weeks on Thursday, yet it failed to stop the forint from tumbling to a record low. Meanwhile, Brazil’s central bank president, Roberto Campos Neto, who presided over the world’s most aggressive tightening cycle this year, cautioned on Wednesday against raising interest rates too fast despite his concern about above-target inflation. 

The real is down more than 7% this year despite 575 basis points of rate increases by the central bank, which has also signaled another 150 basis-point hike in prospect next month. Political and fiscal risks led traders to shrug off the Selic increases.

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“We expect currencies to remain under pressure into year-end and probably into early 2022,” said Paul Greer, a London-based money manager at Fidelity International, whose developing-nation debt fund outperformed 94% of peers this year. “It is difficult for emerging-market currencies to compete with the U.S. dollar at present.” 

These are the events and data to look out for this week:

China’s manufacturing PMIs due Tuesday will probably show the economy steadying in November as pressures from Covid outbreaks and power shortages abate. Even so, the gauges will signal an anemic pace pace of growth, underscoring the need for policy makers to cushion the economy’s slowdown, according to Bloomberg EconomicsSouth Korea’s November inflation is expected to tick lower from a month earlier while still lingering above the central bank’s 2% targetTurkey’s third-quarter gross-domestic product figures on Tuesday may show the economy exceeded its pre-pandemic peakKenya is expected to keep its key interest rate on hold at 7% on Monday after inflation unexpectedly slowed for the first time in six months in OctoberTraders will monitor the quarterly inflation report from the Mexican central bank on Wednesday for clues on the path of monetary policyBrazil will also offer a slew of economic data, with September unemployment figures slated for Tuesday, third-quarter GDP on Thursday and October industrial production on Friday.

©2021 Bloomberg L.P.

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