After a very strong final quarter in 2020, the rally in emerging market currencies stalled in the past couple of weeks, mostly due to the rise in U.S. interest rates. A sharp, unchallenged rise in real rates is typically bad for EM FX, but at this point we think the adjustment higher in rates is mostly a reflection of improved growth and inflation expectations. At this stage of the economic recovery, in combination with the lingering COVID situation, we think it is too early for financial conditions to tighten more meaningfully.

Investors (predominantly fast money) used the move higher in rates to reduce their USD shorts, mainly at the expense of core currencies like the euro. Most EM currencies weakened in sympathy even though the move in general was contained. In a few cases, the weakness was exacerbated on the back of idiosyncratic developments. For example, central banks in Chile and Israel started substantial intervention programs to replenish their FX reserves (Chile) or to fight appreciation (Israel), while the central bank of Poland stepped up intervention to prevent the zloty from appreciating beyond a key level. In Brazil, local investors were hedging their long equity exposure by selling BRL, also given the limited negative carry currently.

Our outlook for EM FX has not materially changed in light of the latest developments. We continue to think that the cyclical recovery will be positive for EM FX and that commodity currencies especially have room to appreciate. We also think that “quality” currencies with healthy economic fundamentals and a high beta to global trade will do well, helped by likely lowered geopolitical tensions. Flows into the asset class (including EM equities) should also remain supportive, and despite the rally late 2020, most EM currencies look cheap on a multiyear basis. As such, we maintain a positive view in FX that we can decompose into commodity currencies like RUB, COP, KZT and BRL, but also to Asian trade- and growth-sensitive currencies (KRW, CNY, INR, SGD and MYR) , Central Europe (CZK, PLN and RON), and high beta currencies MXN and TRY, which are still relatively cheap. Finally, we have some renewed exposure to low-beta frontier currencies such as EGP, GHS, DOP and UYU.