Emerging market currencies are on track for their worst first half of the year since 2020, pushed lower by an unexpectedly strong dollar and an unwind in a popular trading strategy across Latin American markets.
JPMorgan’s emerging markets foreign exchange index has fallen 4.4 per cent so far this year, a drop more than twice as large as the same period in the three previous years. The move has come as investors have torn up hopes of rapid US interest rate cuts in 2024 and nerves around weakening economies and expansive fiscal policies have pushed currencies in some major emerging markets lower.
“It’s the combination of a more resilient economy in the US and, on the emerging markets side, emerging markets like Chile, Hungary and Brazil have kept cutting rates,” said Luis Costa, global head of emerging markets strategy at Citigroup.
“And let’s be honest the prospects for growth in EM are not amazing for this year and the next — there’s a continued contraction in global trade and it’s a very complicated year for elections,” he added.
Much of the recent weakness has come from the unwinding of so-called carry trades, where investors profit from differences in yields between currencies. The trade had been popular with emerging market investors earlier this year.
But in larger emerging markets in particular, these trades have run into trouble as elections made assets more volatile and the future path of local interest rates also became less clear.
Recent weakness in the Mexican peso has been “an example of the unwinding of a sizeable foreign exchange carry trade that was previously building up for two years, from mid 2022 to end-May 2024”, JPMorgan analysts said this week.
The Mexican peso has fallen by almost ten per cent since the country’s ruling Morena party won a landslide victory that stoked concerns about fiscal policy in Mexico and increased interference in the economy. Investors say the effects rippled across other Latin American currencies such as the Colombian peso and Brazilian real.
“LatAm foreign exchange has been the one mostly responsible for the recent weakness — it was kicked off by some of the political changes but there was very heavy positioning in some of the higher carry currencies and it caused the whole trade to unwind,” said Grant Webster, a portfolio manager at fund firm Ninety One.
Some investors have been switching carry trades from larger markets such as Brazil towards smaller, poorer economies that are exiting periods of turmoil and where they believe policies including high interest rates still make bets on local currency bonds attractive, for instance Nigeria and Egypt.
Asian currencies, among the most impacted by a weak Chinese economy, have also struggled this year. The South Korean won has fallen 7 per cent against the dollar, while the Thai baht and the Indonesian rupiah have each fallen around 6.5 per cent.
Currencies around the world have struggled this year to perform against the dollar, which is up 4.5 per cent against a basket of six major currencies, after strong US economic data and sticky inflation forced a big rethink on the outlook for interest rates.
Investors are now betting on two rate cuts by the Federal Reserve this year, down from six or seven at the start of the year.
“A bit more than half of EM weakness has been about dollar strength,” said Kieran Curtis, emerging market portfolio manager at Abrdn. “At the start of the year investors thought there could be six or seven [US] rate cuts this year — and now there could be none.”