Emerging Market Currencies

The market for emerging market currencies is entering an interesting phase. As I mentioned yesterday, global risk aversion is on the upswing. That would suggest a capital flight from emerging markets to more blue chip investments like the US dollar. But conversely, record commodity prices all over the world have boosted demand for these emerging market currencies to an extent that has not been seen in recent years.

To illustrate this dilemma, it’s important to understand what risk aversion does to forex demand in different parts of the world. US Treasury bonds have historically been some of the safer investments internationally. With the recent volatility in the foreign exchange market and the US equities market, demand for bonds has skyrocketed. Bond yields have dropped to 5.07%. Investors have bailed out of riskier investments, including high-yielding and emerging market currencies. Even when bond yields were at record highs a couple weeks ago, empirical data has shown that international central banks had not been the ones to start the sell-off.

But counteracting this flight to safety is the attractive of emerging markets. Brazil is a great example. The Brazilian real is at 1.905 per dollar, up 9.6% this year and 59% over the past three years. The real’s meteoric climb has been supported by a pair of factors. Record commodity prices in iron ore, orange juice and soybeans have led to record current account surpluses. Foreign investment in Brazilian stocks and bonds has led to record capital account surpluses. Most economists believe that the currency level will stay constant for the rest of the year. But there is some hope for short sellers as a vocal minority warns of a drop to 2.5 reals per dollar on the back of lower commodity prices.

The rest of Latin America is caught in a similar situation. Risk-averse investors are cashing out right now. But overall, the appetite for high yields is insatiable. High demand for commodities, from corn to copper to oil, continues to push currencies higher. But investors must proceed with caution. The market for emerging market currencies is relatively illiquid; meaning the risk for potential volatility is much higher.