Emerging market foreign exchange markets are expected to perform better in a potential hard landing scenario than in previous similar episodes, analysts at Bank of America Securities said in a note dated Tuesday.
The note outlines the key shifts in the drivers of emerging market FX since the Covid-19 pandemic, with a focus on potential support from lower oil prices and easing US monetary policy.
Analysts at Bank of America have identified three key factors that have become the primary drivers of emerging market FX performance since the start of the Covid-19 pandemic: US terms of trade, the two-year US swap rate, and Chinese housing prices.
This represents a departure from the pre-Covid-19 period when global growth, particularly as reflected in emerging market export volumes, and commodity prices were the dominant factors affecting emerging market currencies.
Bank of America has observed a strong correlation between U.S. terms of trade and oil prices since the outbreak of the COVID-19 pandemic. This correlation has risen sharply to around 0.94 over the period from January 2020 to July 2024, compared to a negative correlation of around -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.
US monetary policy, particularly the two-year swap rate, has become more important in driving emerging market exchange rates post-Covid-19. A decline in the two-year swap rate, which could result from the Fed easing policy in response to the sharp downturn, is expected to support emerging market currencies.
China’s housing market has also emerged as an important factor in emerging market exchange rates. The report notes that fluctuations in Chinese housing 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—Bank of America analysts expect oil prices and the U.S. swap rate to likely fall for two years. Lower oil prices would worsen U.S. terms of trade, while a lower U.S. two-year swap rate could prompt aggressive monetary easing by the Federal Reserve.
These factors combined are expected to support EM FX, which could lead to better performance compared to previous sharp bearish episodes.
However, analysts also warn that emerging market exchange rate drivers could change in the event of a major credit event, such as a financial crisis or major credit market disruption. In such a scenario, traditional risk-averse sentiment could prevail, leading to a significant weakening of emerging market exchange rates despite potential support from lower oil prices and U.S. monetary easing.
Bank of America’s key components analysis of emerging market FX supports the view that global growth has become less important for emerging market currencies since the spread of Covid-19.
The analysis, which covers data from January 2020 to the present, reveals that US interest rates, the US Dollar Index (DXY), and market volatility (as measured by the US Dollar Index) have become more important drivers of emerging market currencies (EM FX). Global growth indicators, such as emerging market export volumes, now play a less important role.
The first major component of the cost-benefit analysis is primarily influenced by US interest rates and the US dollar index, while the second component is more closely related to US terms of trade and the US balance of payments.
The difference between the BAA and the VIX index for 10 years. Interestingly, the analysis shows that emerging market export volumes, which were closely linked to emerging market FX performance, no longer have the same importance in the post-Covid era.
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