Time to Invest in Emerging Market Currencies?

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on Jun 29, 2021

Updated: Dec 19, 2022

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US inflation has outpaced the emerging market’s inflation rate for the first time on record. Emerging markets’ credibility improves considerably as US inflation outpaces inflation in the developing world.

For the first time ever, US inflation is outpacing inflation in the emerging markets. Developing economies are known for their inflationary pressures, but the last few years have brought some major changes.

One is the improved credibility of emerging markets’ policymaking frameworks when it comes to price stability. Long viewed as one of the major risks when investing in developing economies, emerging markets’ inflation dropped below US inflation for the first time ever.

Will investors turn their attention to emerging markets’ currencies?

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Hawkish Turn in Fed’s Message Triggers Rate Hikes in Emerging Markets

The lack of credibility in local currencies makes investing in emerging markets riskier than in developed ones. As such, investors prefer debt in the world’s reserve currency, the US dollar, rather than in the local currency of the developing economy.

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Therefore, emerging markets have traditionally had a high level of US dollar-denominated debt. Because of that, the changes in the monetary policy in the United States trigger immediate reactions from emerging markets.

For example, two weeks ago, the Federal Reserve of the United States delivered a hawkish message. Its dot plot revealed that the central bank now expects two rate hikes in 2023 instead of only one, thus sending a hawkish signal to the markets that accommodative measures will end soon.

For emerging markets’ currencies to remain attractive to foreign investors, central banks in the developing world immediately raised their interest rate levels, starting with Brazil. On the other hand, improvements in price stability make emerging market investments and currencies even more attractive.

If we look at stock market performance in the last decade or so in the table above, we see that overall, emerging markets’ equities outperformed, but higher inflation than in the developed world made investors cautious.

Now that inflation is subdued and interest rates are rising, investors may turn their attention to emerging market currencies again. The longer the rising US inflation trend continues, the more appealing developing markets’ currencies become for the retail and professional investor.

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