Emerging Markets, the Dollar and the Fed

The talk that QE 1-2-3 may end sparked predictions that the U.S. dollar’s FX value will rise in 2014 and that this will, in turn, hurt emerging markets.  There are risks in emerging markets, as there are in all markets, but the risks stemming from the expected end of QE 1-2-3 seem to be overblown.  While here at home the Fed’s primary concerns are employment and inflation – these are embodied in the laws that created the Fed – the central bank recognizes that financial damage abroad echoes loudly back to the US economy.  The winding down of QE 1-2-3 will raise interest rates somewhat and will be accompanied by improvements in the US economy.  While both these factors are likely to strengthen the dollar, stronger US domestic demand will be a plus for emerging markets.

However, the real action resulting from a stronger dollar is likely to be in the emerging markets, not in the Fed’s board room. The strengthening dollar, along with higher interest rates, will put downward pressure on emerging market currencies. Further borrowing by emerging markets countries, especially in dollars, will become more expensive. The stronger dollar will lower dollar denominated returns to investing in emerging market equities and may also dissuade some investors.

Other factors will offset some of the pressures from the rising greenback. For companies based in emerging markets, when the local currency falls exports priced in the local currency become more competitive while exports priced in dollars (many natural resources) generate larger local currency revenues. On the debt and fixed income side, many emerging market central banks remember the Asian currency crisis of the late 1990s, hold large foreign reserves and can withstand pressures for devaluations and the rising costs of dollar0denominated debts.  The appearance of local bond markets in some developing nations means less borrow in dollars or euros and more debts in their local currency.

For investors looking beyond the US all this is a reminder to do one’s homework.  The factors mentioned here – interest rates, the dollar, and the extent of local currency borrowing or local bond markets, and whether exports are priced in dollars or something else – all matter. And they all vary from market to market; in some emerging markets a stronger dollar might be a reason to invest.

Lastly, as usual there is no guarantee that an end to QE 1-2-3 will lead to a higher dollar.  The chart of the Fed’s Broad Trade Weighted Index of the dollar leaves the next move far from clear.Not Yet a Dollar Revival

The posts on this blog are opinions, not advice. Please read our disclaimers.

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