Investing.com — Emerging market (EM) currencies are expected to perform better in a potential hard landing scenario than in previous similar episodes, BofA Securities analysts wrote in a note Tuesday.
The note notes major shifts in the factors driving emerging market currencies since the COVID-19 pandemic, highlighting the potential support from lower oil prices and an easing of US monetary policy.
Analysts at BofA identify three key factors that have become the main drivers of emerging market currency performance since the start of the COVID-19 pandemic: US terms of trade (ToT), the US 2-year swap rate and housing prices in China.
This marks a break from the period before the COVID-19 crisis, when global growth, especially as reflected in emerging market export volumes, and commodity prices were the dominant factors influencing emerging market currencies.
BofA has observed a stronger correlation between the US terms of trade and oil prices since COVID-19. This correlation increased sharply to approximately 0.94 from January 2020 to July 2024, compared to a negative correlation of approximately -0.87 before the pandemic.
This change reflects the growing role of the United States as a major oil exporter, which has changed the traditional relationship between oil prices and emerging market currencies (EM FX).
The importance of US monetary policy, especially the 2-year swap rate, has increased as a driver of emerging market currencies following the COVID-19 crisis. A decline in two-year swap rates, which could result from Federal Reserve easing in response to a hard landing, is expected to provide support to emerging market currencies.
China’s housing market has also emerged as a key driver for the emerging currency. The report suggests that fluctuations in Chinese house prices are now closely linked to the performance of emerging market currencies, reflecting the broader influence of the Chinese economy on global financial markets.
In the event of a hard landing – characterized by a sharp economic slowdown – BofA analysts predict that both oil prices and the US 2-year swap rate are likely to fall. A decline in oil prices would lead to a deterioration in the US terms of trade, while a decline in the two-year swap rate would be the result of aggressive monetary easing by the Federal Reserve.
Together, these factors are expected to support emerging currencies, potentially leading to better performance compared to previous hard landings.
However, the analysts also warn that the drivers of emerging market currencies could change in the event of a major credit event, such as a financial crisis or significant credit market disruption. In such a scenario, traditional risk-off sentiment could dominate, leading to a substantial weakening of emerging market currencies, despite the potential support from lower oil prices and US monetary easing.
BofA’s Principal Component Analysis (PCA) of EM FX further supports the view that global growth has become less important for EM currencies since COVID-19.
The analysis, which covers data from January 2020 to date, shows that US interest rates, the (DXY) and market volatility (as measured by the ) have become more important drivers of emerging market currencies (EM FX). Global growth indicators, such as export volumes from emerging markets, now play a less important role.
The first principal component of the PCA is mainly influenced by US interest rates and the DXY, while the second is more correlated with US trading conditions.
BAA 10-year spread, and the VIX. Interestingly, the analysis shows that emerging market export volumes, which were once highly correlated with emerging market currency performance, no longer have the same significance in the post-COVID era.
