October 25, 2015 / 9:07 PM / in 4 years

Emerging currencies' fate looms large in rich world rates policy

SYDNEY (Reuters) - The fate of emerging market currencies is looming ever larger in the outlook for interest rates in the advanced world, promising that their central banks will keep policies super loose for some time to come.

A customer is served at a counter at a foreign exchange store in Hong Kong, China, in this August 13, 2015 file photo. REUTERS/Tyrone Siu/Files

Ever since China sprang a surprise depreciation of the yuan in August, the resulting decline of a whole host of emerging market (EM) currencies has produced a disinflationary pulse that the world is ill prepared to withstand.

The danger was clearly much on the mind of European Central Bank President Mario Draghi on Thursday when he all but guaranteed a further easing as soon as December.

“The risks to the euro area growth outlook remain on the downside, reflecting in particular the heightened uncertainties regarding developments in emerging market economies,” warned Draghi, as he sent the euro reeling to two-month lows.

They were also cited as a reason the U.S. Federal Reserve skipped a chance to hike interest rates in September.

In a recent much-discussed speech, Fed board member Lael Brainard put the deflationary pressures emanating from emerging markets at the center of a forceful case against a “premature” tightening in policy.

Fuelling these worries has been a downdraft in emerging market currencies caused in part by worries that higher U.S. rates would suck much needed capital from countries already struggling with large foreign currency debts.

The scale of the shift can be seen in the Fed’s trade weighted U.S. dollar index for other important trading partners, which includes China, Brazil, Mexico and the like.

The dollar index began to take off in mid-July and by the end of September had surged over 6 percent to an all-time high.

The impact was clear in U.S. bond markets, where yields on 10-year Treasury notes US10YT=RR fell from 2.43 percent in mid-July to just 2.06 percent by early October.

Investors expectations for U.S. inflation in five years time USIL5YF5Y=R, a benchmark closely watched by the Fed, sank from a peak of 2.47 percent in early July to hit an historic trough of 1.99 percent three months later.

That in turn saw investors drastically scale back expectations on when and how fast the Fed might hike.

In mid-July, Fed fund futures for December implied a rate of 37 basis points. By early October it implied only 18 basis points.

All of which threatens to become a self-fulfilling cycle where the fear of a Fed hike spurs a steep fall in emerging currencies which in turn stirs concerns about disinflation and prevents the Fed from moving at all.

“It’s a negative feedback loop,” says Robert Rennie, global head of market strategy at Westpac in Sydney.

“China first flipped the switch with its depreciation of the yuan and the risk of capital flight from EM has kept the pressure on,” he added.

“It’s now certain the ECB will ease in December and the Fed will find it tough to hike in December.”

Reporting by Wayne Cole; Editing by Eric Meijer

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