US: Sharp rise in long interest rates to impact emerging market currencies - Natixis

Nordine NAAM, Research Analyst at Natixis, explains that how a sharp rise in US long interest rates to 5% might impact the different asset classes.

Key Quotes

“A rise in US long-term interest rates towards 5% (at end-2018) would clearly have an impact on the forex market and on interest rates in emerging countries. That said, the effects of the rise in US long rates will differ according to two scenarios: under scenario 1, the Fed normalises its monetary policy gradually; scenario 2, meanwhile, is characterised by rising inflation and protectionism. The trajectory of the dollar differs under our two scenarios. In the first scenario, we expect a stronger dollar underpinned by the gradual normalisation of the Fed’s monetary policy. In the second, the dollar is weaker under the effect of rising inflation, US protectionism and weaker global trade, which negatively affects emerging countries.”

“The impact of the rise in US long rates towards 5% will be especially visible in emerging assets, and exchange rates and sovereign bonds (local and external) in particular. In the past, a pronounced rise in US long rates has led to a significant correction in emerging bonds and currencies under the effect of a repatriation of capital and a tightening of monetary policies in emerging countries in order to remain attractive relative to the United States.”

“Since 2010, what will be observed is that emerging currencies are not greatly correlated to the US 10-year rate outside periods of intense strains, during which clearly there is strong correlation. Generally, we note that depending on the country, emerging currencies (against USD) are on occasion more sensitive to changes in local long rates, the dollar’s strength or commodity prices. For example, the tapering in 2013 led to a sharp rise in Hungarian 10-year rates on the back of that in US 10-year rates. However, the DXY dollar index fell during this episode, and it was the influence of the dollar that held sway on the Hungarian forint. In other words, the forint appreciated against the dollar during this period despite the sharp correction in Hungarian sovereign debt.”

“To determine the potential impact of a rise in the US 10-year rate on emerging currencies, we constructed an econometric model for each currency in which we force the use of the local 10-year rate and the DXY dollar index in addition to the other financial variables. We obtain the following estimated percentage changes for each currency for the two scenarios, i.e. strong dollar or weak dollar.”

“In scenario 1 (gradual rise in the dollar), all emerging currencies correct, in particular the South African rand, Polish zloty, Brazilian real and the Hungarian forint. Meanwhile, in the second scenario (fall in the dollar combined with resurgent protectionism and a decline in global trade), most currencies correct with the exception of the Hungarian forint, Polish zloty, Singapore dollar and Chinese yuan, these currencies seeming to be more sensitive to the US dollar than to rising US long rates.”