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Emerging market currencies are on track for their worst first half since 2020, weakened by an unexpectedly strong dollar and the unwinding of a popular trading strategy across Latin American markets.
JPMorgan’s emerging markets foreign exchange index has fallen 4.4% so far this year, more than double the drop over the same period in the past three. The moves come as investors dashed hopes of a sharp U.S. interest rate cut in 2024 and worries over weak economies and expansionary fiscal policies sent major emerging currencies tumbling.
“This is due to a combination of the US economy becoming more resilient and emerging markets, with countries such as Chile, Hungary and Brazil continuing to lower interest rates,” said Luis Costa, global head of emerging markets strategy at Citigroup.
“Let’s be honest, the growth outlook for emerging markets is not great for this year and next, global trade continues to contract and it’s a very complicated year for elections,” he added.
Much of the recent weakness has come from the unwinding of so-called carry trades, in which investors profit from yield differentials between currencies. The trades were popular among emerging market investors earlier this year.
But such deals have faced challenges, especially in large emerging markets, where elections have made asset prices volatile and created uncertainty about the future direction of local interest rates.
The Mexican peso’s recent weakness is “an example of the unwinding of a large foreign exchange carry trade that has been building up over the two-year period from mid-2022 to the end of May 2024,” JPMorgan analysts said this week.
The Mexican peso has fallen nearly 10% since Mexico’s ruling Morena party won a landslide victory that has raised concerns about Mexico’s fiscal policy and led to increased intervention in the economy, with investors saying the effects are spreading to other Latin American currencies such as the Colombian peso and Brazilian real.
“The recent weakness has been largely driven by Latin American currencies, driven by political changes but also by very heavy positioning in some high carry currencies which has led to an overall unwinding of the trade,” said Grant Webster, portfolio manager at fund firm NinetyOne.
Some investors are switching carry trades from larger markets such as Brazil to smaller, poorer economies such as Nigeria and Egypt that are emerging from periods of turmoil and where high interest rates and other policies make investing in local-currency bonds still attractive.
Asian currencies, hit hardest by China’s economic weakness, have also struggled this year: The South Korean won has fallen 7 percent against the dollar, while the Thai baht and Indonesian rupiah have each fallen about 6.5 percent.
Global currencies have struggled against the dollar, which has risen 4.5 percent this year against a basket of six major currencies, as strong U.S. economic data and high inflation have forced a major revision of interest rate outlooks.
Investors now expect the Fed to cut interest rates two times this year, down from six or seven times expected at the start of the year.
“More than half of the emerging market weakness has been due to the strength of the dollar,” said Kieran Curtis, emerging markets portfolio manager at Abrudo. “At the start of the year, investors were expecting six or seven dollar strengthening events. [US] A rate cut was expected this year, but now it looks like there may not be any cuts at all.”
