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EM currency crunch to last beyond Fed hike

The slump in emerging market (EM) currencies could persist well past the U.S. Federal Reserve's first interest rate, due to Chinese economic weakness and commodity prices that have yet to bottom out, analysts have warned.

Expectations of higher interest rates in the U.S., potentially as soon as next month, have sent the U.S. dollar around 20 percent higher against most major currencies in the last 12 months. And with oil and other commodity prices sinking to new depths on an almost weekly basis and China struggling to repair investor sentiment, the picture is likely to remain challenging for EM currencies—which are often strongly tied to commodity prices.

People walk past boards showing currency exchange rates in Moscow, December 17, 2014.
Maxim Zmeyev | Reuters
People walk past boards showing currency exchange rates in Moscow, December 17, 2014.

"We need to find the bottom in the commodity cycle," Kit Juckes, global head of foreign exchange strategy at Societe Generale, told CNBC on Monday.

"There was an enormous resources boom, in everything. Now low U.S. rates and the Chinese boom, both of those are pulling in the other direction at this point in time and we are trying to find the bottom for any commodity you can mention pretty much and the exporters are struggling,".

Malaysia's ringgit plummeted to fresh 17-year lows on Monday on the news that the country's foreign exchange reserves had fallen below $100 billion. Meanwhile, the currencies of Brazil, Russia and Colombian—all of which are oil exporters—have suffered severe bouts of selling in recent weeks.

Other Asian currencies, including Indonesia's rupiah, have also tanked past decade lows.

"It (the ringgit) held up longer, some of the others such as Indonesia and Brazil, they held up longer but now they have started to crack," Juckes said.

"Now we focus on what has happened to some of the foreign exchange reserves in Malaysia's case, to the slower growth and as the China story becomes almost dominant, the theme of weaker economic data across Asia."

Societe Generale forecasts continued volatility in the third quarter of this year, with commodity-linked emerging market currencies top of the piles in terms of weakness.

This comes as crude oil futures touched fresh multimonth lows in Asian trading on Monday, after disappointing data from China, before rallying back towards $50 per barrel later in the session. Brent was up at around $49.76 per barrel after it touched a more-than-six-month low of $48.26 early in the trading session, while U.S. crude climbed to $44.45, shrugging off earlier lows.

Meanwhile, China has been plagued by concerns over stagnating growth, with persistently weak economic data prints. Most recently, Monday saw the steepest fall in China's producer prices since October 2009. This followed from data on Friday that showed manufacturing at 2012 lows.

The JP Morgan Emerging Market Currency Index reached its lowest level on record last week, coinciding with the latest fall seen in commodity prices.

"So far, the fall in commodity prices appears to have been a more important driver of EM foreign exchange weakness than Fed interest rate expectations," Danske Bank strategists said in a note to clients.

However, when the Fed does start adjusting rates, this will likely be further cause for concern, on top of China and commodity price weakness.

"We expect the focus should shift from the collapse in commodity prices to higher U.S. rates, suggesting that EM currencies will weaken further near-term," Danske Bank said.

"The EM countries which are particularly vulnerable to higher USD funding costs are the ones where current account deficits are large and expanding. In this group fall Latin American countries like Brazil, Mexico and Colombia," the strategists added.