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US Dollar's Surge and Its Impact on Emerging Markets

A surging US dollar has set off the biggest sell-off in emerging market currencies since the early stages of the Federal Reserve's aggressive rate-raising campaign. The JPMorgan index of EM currencies has fallen more than 5 per cent over the past two-and-a-half months, marking its biggest quarterly decline since September 2022. This decline is widespread, with at least 23 currencies tracked by Bloomberg falling against the dollar this quarter. The greenback's strength is driven by expectations that US president-elect Donald Trump will impose sweeping trade tariffs and loosen fiscal policy. For example, Trump's announcement of levies on imports from Mexico and China has had a significant impact. The Mexican peso has fallen 2.1 per cent this quarter, and China's offshore renminbi is down 3.7 per cent.Even when considering the interest earned from holding assets in local currencies, only very risky currencies like Turkey and Argentina have shown positive returns for investors this quarter. The breadth of the post-election sell-off has also affected carry trades, where investors borrow in lower interest rate currencies to buy higher-yielding EM currencies. A basket of popular EM carry trades tracked by Citi has returned only 1.5 per cent this year.

Specific Challenges Facing Different EM Currencies

Analysts note that weakness in the Mexican peso can be attributed largely to tariff developments. However, for many other EM currencies, the picture is more complex. In China, concerns about the slump in the domestic economy and the prospect of further central bank easing policy are weighing on the currency. Yields on China's benchmark 10-year bonds have fallen below 2 per cent to their lowest level in 22 years.In Brazil, concerns about deficits and debt sustainability are driving the real to record lows. It has broken through the threshold of six to the dollar despite a new government promise to find cost savings. "Brazil has a fiscal crisis on its hands," says Ed Al-Hussainy.In South Korea, the won was hit after President Yoon Suk Yeol declared martial law (a decision he later retracted). The surging dollar has also pushed the euro lower, affecting EM currencies that "orbit the euro" like the Polish zloty and the Hungarian forint.Macquarie's Thierry Wizman highlights that the sell-off in developing market currencies has revived the "Tina" investment narrative, suggesting there is no alternative to investing in the US. "There aren't any emerging markets these days that stand out as having robust economic stories," he adds.Additional reporting by Joseph Cotterill in London provides further context and details to this complex economic story.

Emerging-market currencies have been in a state of flux, with recent events shaping their trajectories. In this article, we delve deep into the factors influencing these currencies and their implications.

Unraveling the Dynamics of Emerging-Market Currencies

Inflation and Federal Reserve Bets

Emerging-market currencies saw a trimming of losses after inflation in the US came in line with expectations. This solidified bets that the Federal Reserve will lower interest rates. An index of emerging market currencies traded flat after the data, offsetting part of the negative sentiment sparked by a weakening yuan earlier in the session. An index of emerging stocks also fell for a second day. This shows the interconnectedness of different markets and how one event can have ripple effects.

Strategist Alejandro Cuadrado from BBVA in New York noted that the data was generally in line with expectations, and this led to a period of less volatility and less noise. Traders priced in about 23 basis points worth of easing at the Fed’s December meeting, compared to 20 basis points prior to the inflation report. Markets now see a roughly 92% probability that the Fed will lower its benchmark by a quarter-point next week.

Yuan's Tumble and Its Ripple Effects

The Brazilian real and the South African rand were leading advances, while Asian and Eastern European currencies posted the biggest losses. Earlier, the offshore yuan sank as much as 0.5% to 7.2921 per dollar after Reuters reported that Beijing may let the currency weaken further next year to offset the impact of potential US tariffs under President-elect Donald Trump.

China’s yuan has been falling this quarter as policymakers intensify monetary stimulus to make exports more competitive. This depreciation raises risks of capital outflows and financial instability, which could ripple through emerging markets tied to demand from the world’s second largest economy. The correlation between China’s exchange rate and a broader developing-nation FX gauge climbed to the highest since June, underscoring how tariff strategies between the US and China remain a central risk for emerging markets.

Other Emerging-Market Developments

In Brazil, Luiz Inacio Lula da Silva continues to recover from brain surgery. The nation’s central bank is expected to increase borrowing costs for a third straight time on Wednesday. In Ukraine, dollar bonds led gains across emerging markets, extending a month-long rally on speculation that Trump’s presidency paves the way for talks to end its fight against Russia’s invasion sooner. In South Africa, the inflation rate crept up by less than expected in November amid benign food-price growth, creating room for the central bank to cut borrowing costs again next month.

These various developments in different emerging markets highlight the complexity and diversity of the global economic landscape. Each country and region is facing its own set of challenges and opportunities, and understanding these is crucial for investors and policymakers alike.