Analysis: Fed will reinforce divergence among emerging market currencies

The Turkish lira and Brazilian real are the worst performing emerging market currencies year-to-date despite the interesting interest rate spread they offer in terms of carry trading in the current environment of zero, and even negative interest rate policies, writes Ipek Ozkardeskaya of London Capital Group.

The former has lost more than 15% of its value since January 2015 just as the Brazilian real has dropped by a hefty 20%, significantly underperforming their emerging Asian peers, with the Indian rupee down 0.95%, Philippine’s peso off by 1.71% and even Russia’s rouble declining 3.86%.

More interestingly, thus far in 2015 investors have witnessed a clear divergence among the famous Fragile Five – Turkish lira, Brazilian real, South African rand, Indian rupee and Indonesian rupiah. This group of currencies used to be clumped together due to their countries’ high current account deficits and therefore their high sensitivity to US Treasuries, that is to say, to Federal Reserve policy.

However, since the start of the year the debasement of energy and commodity prices has become a leading macro driver in the foreign exchange arena, ahead even of policy remarks from Fed speakers.

That has driven an even bigger wedge between the performances of each of those currencies.

Political tensions have been an additional facewind for Brazil and Turkey offsetting the benefits of the slump in oil prices for Turkey and notable monetary tightening in Brazil.

Now that the Fed is ready to step back into the spotlight, should we expect a convergence toward a mean in this Fragile Five complex, or is the Fragile Five story doomed to gather dust?

It all depends on how the Fed decides to proceed. If it moves towards a more orthodox policy stance then the stronger US dollar is not bad news per-se.

Cheaper local currencies increase the competitiveness of emerging market businesses and serve to boost US denominated revenues. Yet the debasement of commodity prices prevents the companies that export them from fully taking advantage of strength in the Greenback

This being said, the business focus of the above-stated countries will certainly become crucial in this new cheap commodity setting.

Leaving the political dimension aside, the position of these countries in the commodity space could become a major driver as the Fed starts normalising its policy.

EM currencies are likely all predestined to depreciate against the US dollar, so the slide in commodity markets will put further weight on commodity exporters’ current accounts while local companies' US dollar denominated debt tax their balance sheets.

As the revenues derived from natural resources tumble, the relative manufacturing and industrial performances will be critical. From this angle, South Africa, Brazil and Indonesia have more to suffer while India and Turkey display interesting potential within the next twelve months.

In Turkey, however, increasing unrest on the Syrian border and the attendant political uncertainties merit a cautious approach on the part of investors.

This line of reasoning leads us to look at a long rupee position against the real and the rand and the result could not be more straightforward: the trend is already underway and the divergence between the emerging market currencies is set to deepen.

The rupee has appreciated 40% against the rand during the past three years, recovering half of the losses which materialised since 2008.

It may be just a matter of time before the rand-rupee falls below the critical 5.0 mark and leans towards a consolidation within the 4.80/5.00 zone.

Versus the real, the rupee is in a position to extend gains to fresh 10-year highs with rupee-real targeting 17.50. This scenario may unfold within the next three-to-six months.

Ipek Ozkardeskaya is a market analyst at London Capital Group.