A Reuters poll found that emerging market currencies will struggle to hold onto recent gains towards the end of the year as U.S. Federal ReserveFederal Reserve hikes and inflation concerns keep the dollar in the forefront.
Positive sentiment in emerging market currencies has already soured by higher U.S. Treasury yields, as it is barely recovered from a nearly two-year bear run.
A month ago, safe-haven dollar inflows pushed the emerging markets currency index to its lowest level since the end of 2020. Markets scaled back a bit on aggressive Fed hike bets, weakening the dollar.
In the May 30 -- June 1 poll, a majority of FX strategists said the dollar's recent weakness would be short-lived and it would strengthen against most emerging market currencies by the end of August.
Min Dai, FX strategist at Morgan Stanley said that it was a perfect storm for EM local markets in 2022, a hawkish Fed, the Russia-Ukraine conflict, the Russian debt sell-off and a slowdown in China.
After a painful 2021 period, we hoped that EM could recover in 2022, but the reality is the opposite. Almost all of the emerging market crises were linked to dollar strength. As the dollar rises, developing countries must tighten their monetary policy in order to prevent falls in their own currency. Not doing so would cause inflation and increase the cost of servicing dollar-denominated debt.
The EM story won't turn positive unless U.S. inflation starts to turn. Dai said that valuations are cheap and positioning is clean, but this is not enough for investors to turn constructive.
On Wednesday, the dollar index increased as Treasury yields climbed and investors' risk appetite was kept at bay by worries about a further acceleration in global inflation.
Societete Generale's Phoenix Kalen said the spectre of high and sticky inflation is likely to haunt markets in the near term due to a choppy global growth outlook.
That will give emerging market assets a lot of opportunities to break out of recent ranges.
The fate of a broad range of EM currencies will be tied to CNY's Chinese yuan behavior in the coming period. Asia FX and EM commodity currencies such as Latam FX and ZAR South African rand remain susceptible to near-term weakness due to their links with CNY, Kalen said.
South Africa's rand has a somewhat stable outlook compared to other EM currencies. The rand was expected to erase most of its gains this year, falling more than 2.0% to 15.65 Turkey's lira is down nearly 20% this year, as Turkey's central bank slashed interest rates even as inflation was soaring. In May, inflation is expected to reach 76.55%.
The lira, the worst performing emerging market currency this year, is set to fall about 9% to 18.00 in the next 12 months.
Russia's rouble, which was propped up by capital controls and has artificially risen to become the world's best-performing currency this year, is expected to fall by more than 20% to 76.67 in a year.
Not all is well in Asia. China's tightly controlled yuan was predicted to depreciate 1.0% to 6.71 per dollar in a year, as analysts warned a shrinking yield gap between Chinese and U.S. 10 year government bonds could cause capital outflows.
The Indian rupee, which hit a record low of 77.73 against the dollar last month, was expected to hit a new low of 78 in the next six months.