Trade wars and slowing China economic growth are having a major impact on emerging market currencies in 2019. We unpack the recent events and consider what the next moves for U.S. interest rates could mean for emerging markets FX in 2020.
- Emerging market currencies have suffered their worst performance since Turkey’s lira crisis in 2018.
- The U.S.-China trade war and a slowdown in China’s economic growth to a three-decade low are having a major impact on emerging market currencies.
- U.S. Federal Reserve rate cuts will put additional pressure on the U.S. dollar and may lead to cash outflows, with a positive gain for emerging markets.
Trade tensions between China and the United States — the world’s two largest economies — have caused emerging market currencies to suffer their worst performance since Turkey’s lira crisis in 2018.
In May 2019, President Trump increased tariffs on US$200 billion of Chinese imports to 25 percent from 10 percent. In addition, $300 billion worth of Chinese goods were placed under review.In return, China announced it would increase tariffs on $60 billion worth of imports from the United States as of 1 June 2019. Chinese tariffs on some goods including computers, agriculture, and LNG would be as high as 25 percent.
Slowing China growth
China’s offshore renminbi weakened to its lowest since November 2018 at nearly three percent in July 2019. Emerging market bond and equity funds experienced significant outflows, while flows into dedicated bond and equity emerging market funds fell to around $5 billion.
Another impact on emerging market currencies has been China’s slow economic growth.
China’s GDP fell to 6.2 percent in the second quarter, its slowest rate in nearly 30 years. This largely tied into the country’s trade war with the U.S., which has delivered a huge blow to its exports.
Housing, construction and other indicators of investment sentiment contracted from June 2019 onwards. Domestic growth, however, exceeded expectations and strengthened, especially retail sales and industrial output.
U.S. recession fears
At the same time, President Trump is pressing the Federal Reserve to lower interest rates by as much as one percent as the economic outlook worsens. Yields were hovering at the lowest in over a year amid signs that the Fed will cut interest rates before January 2020.
At a meeting in July 2019, the Federal Reserve cut interest rates by 25bps overnight to a 2 percent to 2.25 percent range, framing it as insurance against downside risks or weakness in global growth due to the trade tensions.
This mid-cycle adjustment, even though it has sent a strong dovish signal, could change in the upcoming months due to ongoing economic slowdown fears being priced in by the bond market.
A widely-used bond market indicator of recession— the difference between the two-year and 10-year Treasury yields — sent its strongest signal since the sub-prime crisis in 2017.
This inversion of the yield curve (shorter-term rates are higher than longer-term ones) has preceded every U.S. recession of the past half century.
Upturn for emerging market currencies?
U.S. rate cuts will put additional pressure on the U.S. dollar and may lead to cash outflows, a positive gain for emerging markets. China is also expected to diversify its trading partners in search of new trade deals.
Notably, quantitative easing by G3 nations in recent years has helped funnel funds to emerging markets in search of yields.
All else being equal, a weaker U.S. dollar is generally favorable for emerging market assets because it makes it easier to service dollar-denominated debt.