Emerging markets beware, a stronger dollar is coming
With rate hikes by the Federal Reserve looming, US dollar bulls are cheering. Trouble is, when the dollar strengthens, emerging markets (EMs) feel the heat. The reverse is true, too. For perspective—the MSCI EM index has gone up 28.8% from 1 January till 8 December whereas the US Dollar Index has lost 8%. The accompanying chart shows the inverse relationship between the two measures since 2012.
However, the roles look set to reverse what with the Fed rate hike around the corner. “The US dollar, most likely, will start 2018 from a position of strength,” says Gaurav Kapur, chief economist at IndusInd Bank Ltd, adding that interest rate expectations are driving the dollar at the moment.
According to Saurabh Mukherjea, chief executive of Ambit Capital Pvt. Ltd, “If the US Congress approves the tax cut plan, the US economy, which is already doing well, could potentially start overheating. Therefore, the Fed might push through rate hikes faster than expected.”
A combination of these factors will start exerting upward pressure on the dollar, reckons Mukherjea.
The rise in US bond yields already reflects these expectations. Higher bond yields typically mean that funds flow out of EMs or risky assets. Importantly, this could well be the signal the world needs that the era of quantitative easing is behind us, he said.
“What this means is that the risk asset classes whether they be Bitcoin or emerging markets or tech stocks in the US will be repriced down to sensible levels,” added Mukherjea.
But will the implementation of tax reforms alone in the US lead to a strong recovery in the dollar compared to other currencies? Kotak Institutional Equities sees tax reforms as quite likely although the House and Senate would have to reconcile differences in the two bills for a common bill.
But here’s what can make the going not so predictable. “US politics will likely continue to be too dysfunctional for any bipartisan initiatives on other reforms in light of the ideological differences between the two major parties,” wrote analysts from Kotak in a note on 8 December. “In fact, the mid-term congressional elections could further complicate matters if the Democratic Party were to gain a majority in the House of Representatives.”
According to IndusInd Bank’s Kapur, after the initial months, an element of surprise will come if US economic growth is faster or if wage growth and inflation pick up. “This means you will see the US dollar outperforming other currencies,” he said.
Even as the long-term picture is not so clear at the moment, the fact that many analysts see a stronger dollar in the near term means pressure for EM equities and their currencies.
However, countries that have a high fiscal deficit and current account deficit, and a huge dollar debt are likely to get hit relatively more, says Ritesh Jain, chief investment officer at BNP Paribas Asset Management India Pvt. Ltd.
As far as India is concerned, a strong dollar and firm crude oil prices should make us uncomfortable.