Best EM currency trades lose steam amid new rate hikes

Some of the year’s best-performing emerging-market currencies may lose favour as the rationale for rate hikes to tackle inflation shows early signs of waning.
The Brazilian real and the Russian rouble have already come under pressure this quarter, with traders speculating central banks may pull back on the pace of monetary-policy tightening. Both currencies were among the best performers through the first half of the year, but have since taken a hit, with the real sinking about 4.5% since the end of June, more than any other major currency tracked by Bloomberg.  
The tightening cycle was in full force in emerging markets long before the US Federal Reserve started laying out a timeline for scaling back its bond-buying programme, which Chair Jerome Powell said on Friday could begin as soon as this year.
The early hikes in Russia and Brazil have helped stem flows from emerging markets, though policymakers are still balancing the need to battle inflation with the desire to support economies battered by Covid-19.
Brazil’s central bank has already increased its key rate by 325 basis points this year, more than most peers, and forward-market bets are pricing in slowing rate hikes after September’s meeting.
In Russia, traders expect the central bank to increase its benchmark by about 50 basis points over the next three months, down from more than 130 points in early July.
“Early hikers, where the speed of tightening has been in line with or in some cases faster than historical hiking cycles, are likely to slow the pace of hikes or pause in the months ahead,” Goldman Sachs Group Inc. strategists led by London-based Kamakshya Trivedi said in a note this month. “The second half of the emerging-market hiking cycle is likely to be even broader, with more central banks commencing some form of normalisation.”
Next to hike: This evolving rate environment presents a crucial opportunity for traders to take advantage of variations in the next phase of the emerging-market tightening cycle, according to Goldman Sachs.
South Korea became the first major Asian country to raise interest rates on Thursday, with more hikes in the pipeline as the focus pivoted from propping up the economy to curbing a debt-driven asset bubble. Poland and Colombia could be next.
That offers some upside potential for lagging currencies such as the Korean won and Polish zloty, protecting their relative yield advantage against accelerating prices and the prospect of rising US rates.
The won rose before relinquishing its gains after South Korea’s central bank governor remained ambiguous on the timing of the next move.
The currency should strengthen on a hawkish “Bank of Korea, economic resilience and a technically oversold won,” said Mitul Kotecha, chief emerging markets Asia & Europe strategist at TD Securities in Singapore.
“Markets will likely continue to chase yield, meaning those countries, with relatively aggressive monetary stances and higher real yields will benefit most,” Kotecha said.
Balancing act: It’s a delicate balancing act for policymakers, who have to battle rising prices without stifling growth as the threat of Covid-19 variants continues to loom over the global economy. Poland for one has signalled it wants to keep monetary policy loose until the economic rebound is well under way despite surging inflation.
Still, the eastern European country may be the next in line after the economy expanded at its fastest-ever annual pace in the second quarter, with Deutsche Bank AG predicting hikes in October and November. The zloty this year has underperformed the currencies of Hungary and the Czech Republic, which have embarked on aggressive monetary-tightening campaigns to keep inflation under control.  
Poland stands out as an emerging market that has been “behind the curve when it comes to raising rates,” said Oliver Harvey, a London-based strategist at Deutsche Bank. Its dovish policy stance has weighed on the currency, which the bank says is about 10% undervalued based on its models. If the central bank were to turn more hawkish later this year, the zloty could be a catch-up trade, he said.
Fresh hawkish sentiment is also emerging in Colombia, where the central bank has signalled it may soon join the regional trend for higher interest rates as inflation accelerates. Policymakers see the economy expanding at 7.5% this year. Economists surveyed by the bank see policy makers increasing the key rate by 75 basis points this year, from a record low of 1.75%.
In the coming week, investors will also watch rate decisions from Chile and Zambia.
Policy cues: Chile’s central bank is expected to increase its key interest rate by 50 basis points while employing a more hawkish tone amid fiscal stimulus measures and higher-than-expected inflation readings.
Zambia’s central bank is expected to leave rates unchanged, with inflation slowing as the kwacha’s world-beating streak helped rein in import costs.
In Mexico, investors will scour the quarterly inflation report to be released by the central bank on Tuesday for clues on the path for monetary policy.
Turkey’s August inflation reading due Friday will be closely watched as it will likely influence the next monetary policy decision on September 23. Drawn to the nation’s yields, investors have been returning to Turkey’s debt market amid relief that the new central bank governor hasn’t succumbed to President Recep Tayyip Erdogan’s calls for lower interest rates.
Data on Wednesday will probably show Turkey’s economic growth accelerated to 21% in the second quarter from a year earlier because of a favourable base effect
“The momentum of economic activity is likely to continue to soften going forward in the face of the ongoing uncertainty about the pandemic situation, elevated FX volatility and interest rates,” Citigroup Inc. economists, including Ilker Domac and Gultekin Isiklar, wrote in a note
PMI data: China’s data will offer a first look at how the economy fared in August after sweeping curbs were reimposed to contain the spread of the delta variant. Manufacturing and non-manufacturing PMIs are set to be released on Tuesday.
The China figures will reflect the impact of the latest Covid-19 cases, which resulted in closures at marine ports and airports, with knock-on effects to trade and industry as well as tourism and leisure, according to a note from ING Group analysts led by Robert Carnell in Singapore. The yuan has weakened this month.
South Korea, Taiwan, Malaysia, Indonesia, Thailand and the Philippines will release gauges of factory activity on Wednesday. China’s Caixin manufacturing PMI is also due on the same day.
India is expected to report on Tuesday that its GDP growth quickened to 21% in the second quarter from 1.6% in the previous three months due to a low base effect. The year-on-year growth rate masks the underlying weakness caused by the latest Covid-19 spread, which was much deadlier than last year, according to ING.
The Indian rupee has lost about 1% this year.