The traditional thinking is that the start of a Fed tightening cycle is generally bad for emerging market FX and LATAM in particular, but that thinking should be challenged this time around. For starters, this isn’t like any other tightening cycle. We’re starting from a much lower base, we’ve seen a large expansion of the Fed balance sheet and the Fed has done more than ever before to prepare markets.
If we look back to the two prior Fed tightening cycles of 1998 and 2004, Latam FX struggled in the subsequent 6 months in the wake of the first move. Back in 1998, it had just about recovered, at the end of this period, but this was during the turbulent times following the Russian and LTCM crisis. In 2004, when the Fed started tightening from 1%, it was more of a struggle, with the initial losses having failed to be reversed in the months afterwards as the Fed continued to tighten to 2.25% by year end (see chart).
In the wider picture, we’ve seen a substantial depreciation of emerging market FX. Over the past year, broad indices show EM FX to be 15% weaker, with emerging market currencies down 30% since the 2011 highs. Latam has not escaped this, but most of the depreciation has come from Brazil, the Real down nearly 25% over the past 12 months. But what we’ve seen on the Real, together with the generalised weakness in emerging market FX and the amount of signalling we’ve had from the Fed all combine to suggest that it’s going to be more domestic issues that are the main risk to Latam currencies in 2015, rather than Fed tightening per se.
In contrast, Mexico is economically and geographically best placed to benefit from the on-going recovery in the US economy. As for the Columbian peso, there looks to be further vulnerability ahead. Lower energy prices and a deteriorating current account deficit are likely to push USDCOP towards the 2800 level in the latter half of the year.