Investors looking to bottom-fish and find value in the emerging markets currency basket space will do well by telling themselves: What’s cheap can get cheaper. Last week, the foreign exchange markets witnessed a sharp sell-off in the emerging markets currency space over concerns of the future policy path of the US Federal Reserve and disappointing Chinese economic data.
The last couple of quarters have witnessed a massive outflow of funds from emerging markets (EM) currencies into (developed markets) DM currencies as economic growth in the developed world reverts back to pre-crisis levels. The South African rand, the Brazilian real, the Turkish lira and the Mexican peso all depreciated more than two percent against the US dollar last week.
Historical price levels were reached last week with the lira plunging to a record low. The rand also dropped to its lowest level in five years while the real fell to a six- month low. The hardest hit was the Argentine peso, which witnessed its largest intra-day fall last week and has given up about 18 percent of its value this year.
Foreign exchange reserves of many of these nations are running out at an alarming speed due to an effort to shore up their currencies. Turkey, for example, last week spent in excess of $3 billion to provide support to its dwindling currency. But its reserves stand at a mere $33 billion now, and clearly this intervention in the fx market cannot continue.
Currency strategists are expecting another leg down in the EM currency space to the extent of 5-10 percent. The price action in the EM currencies has also impacted major DM currency pairs such as the dollar/yen, pound/dollar and the aussie/dollar. Risk aversion and an inflow of money into the US dollar, which is viewed as a safe haven currency usually leads to a sell off in these pairs.
It is important to note here that Australia wants its dollar to be trading close to 0.85 to the US dollar, while Japan via its own quantitative easing measures is attempting to further weaken the Yen driving it past the 105 level. But the momentum to the downside in the Australian dollar may drive it past the 0.85 level in the coming weeks and the Yen can further strength against the dollar.
Thus, although it is a very low probability scenario, if the sell off in the emerging currency market does not abate, we may see some foreign exchange intervention from the Australian and the Japanese central banks.
The Federal Open Market Committee (FOMC) will be announcing its rate decision Wednesday. US data has not surprised to the upside in recent weeks and Ben Bernanke is widely expected to keep its asset purchases of $75 billion a month unchanged. This might provide a short term pullback in US yields, which would drive the dollar lower and thus support emerging market currencies. But this will not be a fundamental fix as the secular trend for the dollar remains bullish as US monetary policy normalizes.
Emerging market countries worst hit by their depreciating currencies will have to address domestic structural problems to prevent future speculative attacks which take their currencies to massively oversold levels.
Lessons can be taken from India in this respect, which via various measures has managed to the stabilize the slide in the Rupee over the last six months. The Indian Rupee has largely outperformed its peer EM currencies this year.
The ideal trading strategy to deploy for the EM currency space for now is a wait and watch game. With such enormous selling pressure and liquidation out of EM currencies, picking a bottom at this point of time would be like catching a falling knife.
(Vatsal Srivastava is a senior market analyst. The views expressed are personal. He can be contacted at firstname.lastname@example.org)