Lower oil, Fed easing would support EM FX in hard landing: BofA

Investing.com -- Emerging market (EM) foreign exchange (FX) is expected to perform better in a potential hard landing scenario than in previous similar episodes, as per analysts at BofA Securities in a note dated Tuesday.

The note mentions key shifts in the factors driving EM FX since the COVID-19 pandemic, emphasizing the potential support from lower oil prices and easing U.S. monetary policy.

Analysts at BofA identify three main factors that have become the primary drivers of EM FX performance since the onset of the COVID-19 pandemic: U.S. terms of trade (ToT), the U.S. 2-year swap rate, and China’s house prices.

This marks a departure from the pre-COVID period when global growth, especially as reflected in EM export volumes, and commodity prices were the dominant factors influencing EM currencies.

BofA has observed a strengthened correlation between U.S. terms of trade and oil prices since COVID-19. This correlation has risen sharply to approximately 0.94 during the period from January 2020 to July 2024, compared to a negative correlation of around -0.87 before the pandemic.

This change reflects the United States' growing role as a major oil exporter, which has altered the traditional relationship between oil prices and emerging market currencies (EM FX).

The importance of U.S. monetary policy, particularly the 2-year swap rate, has increased in driving EM FX post-COVID. A decline in the 2-year swap rate, which could result from Federal Reserve easing in response to a hard landing, is anticipated to provide support to EM currencies.

China’s housing market has also emerged as a significant factor for EM FX. The report suggests that fluctuations in China’s house prices are now closely tied to the performance of EM currencies, reflecting the broader influence of China’s economy on global financial markets.

In the event of a hard landing—characterized by a sharp economic slowdown—the BofA analysts project that both oil prices and the U.S. 2-year swap rate would likely fall. A decrease in oil prices would lead to a deterioration in U.S. terms of trade, while a fall in the 2-year swap rate would result from aggressive monetary easing by the Federal Reserve.

Together, these factors are expected to support EM FX, potentially leading to a better performance compared to past hard landing episodes.

However, the analysts also caution that the drivers of EM FX could change in the event of a major credit event, such as a financial crisis or significant credit market disruption. In such a scenario, the traditional risk-off sentiment could dominate, leading to a substantial weakening of EM FX despite the potential support from lower oil prices and U.S. monetary easing.

BofA's Principal Component Analysis (PCA) of EM FX further supports the view that global growth has become less important for EM currencies since COVID-19.

The analysis, covering data from January 2020 to the present, reveals that U.S. interest rates, the U.S. Dollar Index (DXY), and market volatility (as measured by the VIX) have become more significant drivers of emerging market currencies (EM FX). Global growth indicators, such as EM export volumes, now play a less important role.

The first principal component of the PCA is primarily influenced by U.S. interest rates and the DXY, while the second is more correlated with U.S. terms of trade, the U.S.

BAA 10-year spread, and the VIX. Interestingly, the analysis shows that EM export volumes, which were once highly correlated with EM FX performance, no longer hold the same significance in the post-COVID era.

This article first appeared in Investing.com