Oil falls, Fed easing would support EM FX in hard landing: BofA By Investing.com

Investing.com — Emerging market (EM) currencies are expected to perform better in a potential crash scenario than in previous similar episodes, analysts at BofA Securities said in a note on Tuesday .

The note notes key changes in EM FX drivers since the COVID-19 pandemic, highlighting potential support from falling oil prices and easing US monetary policy.

BofA analysts identify three main factors that have become the main drivers of EM FX performance since the onset of the COVID-19 pandemic: US terms of trade (ToT), the US 2-year swap rate and Chinese house prices.

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

BofA has seen a strengthened correlation between US terms of trade and oil prices since COVID-19. This correlation increased sharply to about 0.94 in the period January 2020 – July 2024, compared to a negative correlation of about -0.87 before the pandemic.

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

The importance of US monetary policy, especially the 2-year swap rate, has increased in boosting EM FX after COVID. A decline in the 2-year swap rate, which could result from Federal Reserve easing in response to a hard landing, is expected to provide support to EM currencies.

China’s real estate market has also become a significant factor for EM FX. The report suggests that house price fluctuations in China are now closely linked 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 – BofA analysts project that both oil prices and the US 2-year swap rate would likely fall. A decline in oil prices would lead to a deterioration in US terms of trade, while a decline in the 2-year swap rate would result from the Federal Reserve’s aggressive monetary easing.

Together, these factors are expected to support EM FX, which may lead to a better performance compared to previous hard landing episodes.

However, 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, traditional risk-off sentiment could dominate, leading to substantial EM exchange rate weakness, despite potential support from lower oil prices and US 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 date, shows that US interest rates, (DXY) and market volatility (as measured by ) have become more important 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 APC is primarily influenced by US and DXY interest rates, while the second is more correlated with US terms of trade, US

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