Emerging market currencies are under pressure and increasingly moving in the same direction -- here's why you should be taking notice

Arnold H. Drapkin/The LIFE Images Collection/Getty ImagesView of the Sultan Ahmed Mosque at sunset. Istanbul, Turkey.
  • Emerging market currencies are under pressure, and increasingly moving in the same direction.
  • HSBC says this may be a sign of growing financial and economic contagion risks.
  • It is particularly wary of nations that have large external debts and run current account deficits.

Having been under pressure since early 2017, the US dollar index, or DXY, has reversed course in recent months.

It’s now up over 6% since mid-February, briefly hitting the highest level since December last year on Monday.

While the DXY’s recent strength reflects gains against the euro and Japanese yen, the US dollar has also strengthened against other currencies, especially those from emerging markets (EM).

As seen in the chart below from HSBC, the greenback has recorded solid gains against all EM currencies since April 24, the day the DXY rally really took off.

HSBC

Rather than being about traders reversing bearish bets on the greenback, as seen in recent positioning data from the US Commodity Futures Trading Commission, HSBC says the combination of a higher greenback, higher US bond yields and strength in crude oil prices has also been a factor.

“We remain cautious towards EM FX as currencies, particularly the higher yielding ones, are struggling to stabilise,” it said in a note released on Monday.

“A stronger USD alongside firmer US yields does not bode well for EM FX. All the more so when we throw higher oil prices into the mix.

“This combination last occurred in November 2016 and September 2017, and EM FX also struggled versus the USD during those episodes.”

HSBC, pointing to the chart below, also notes correlations within EM FX have risen over the past six months, which it says is a sign of building stress.

Strong positive correlations, indicating that currencies are moving in the same direction, are represented by dark red while strong negative correlations are represented by dark blue.

HSBC

“At the moment, this heat map is dominated by swathes of red,” HSBC says.

“Most USD-EM pairs have been moving together in a synchronised manner recently because they are being driven by common external factors [such as tighter US monetary policy, trade tensions between the US and China, increased financial market volatility and sharply higher oil prices].

“However, it is also possible that their movements may be increasingly due to contagion risk from within.”

HSBC says this contagion could be through financial channels — sentiment, global investor portfolio flows or the pricing of new bond issuance — as well as reflecting real economic linkages such as trade and tourism.

It also notes that portfolio inflows to emerging markets have been pretty much non-existent so far this year, instead dominated by outflows across equities and bonds.

More importantly, it says outflows have also been seen from most nations, regardless of whether they run a current account surplus or deficit.

“As the saying goes, a chain is only as strong as its weakest link,” HSBC says.

“It is thus important to pay attention to what policymakers in some of the hardest hit economies are doing to alleviate the stress in their respective currencies.

“Their actions could set the tone for broader risk sentiment towards EM FX, at least temporarily.”

In particular, HSBC is wary about those nations with high levels of external debt and sizable current account deficits.

“We stay cautious on those EM currencies with large external funding gaps,” it says, referring to the chart below.

HSBC

“That said, those that have already weakened significantly and whose central banks have taken strong steps to alleviate the market’s concerns may see some temporary relief.

“It’s going to be bumpy.”

NOW WATCH: Money & Markets videos

Business Insider Emails & Alerts

Site highlights each day to your inbox.

Follow Business Insider Australia on Facebook, Twitter, LinkedIn, and Instagram.