A resurgent USD will greatly impact Emerging Market economies and the technical picture does not bode well for EM.
The daily chart below shows the CEW ETF, were its new 2023 highs were not confirmed by new USD lows, an important non-confirmation. At the same time the CEW ETF reached the upper bound of its channel and has currently traced out a H + S pattern with equidistant shoulders. Break below the neckline, will likely see the downside accelerate. Investors with EM exposure would be wise to deploy appropriate hedging strategies. Below the chart an excerpt from the imf.org website explaining why USD strength impacts Emerging Markets.
All charts were created using Tradingview.com – one of the best charting platforms out there!
‘Emerging market economies can suffer during periods of US dollar appreciation due to several factors:
- Trade and Financial Channels: The effects of a strong dollar spread via trade and financial channels. Real trade volumes in emerging market economies decline more sharply, with imports dropping twice as much as exports1. These economies also tend to experience worsening credit availability, diminished capital inflows, tighter monetary policy, and bigger stock-market declines1.
- Capital Outflows: A strong U.S. dollar can lead to capital outflows as money invested overseas returns to the safer confines of the U.S2. This can be particularly damaging for emerging markets that are heavily reliant on the flow of foreign investment cash from the U.S. and other developed nations2.
- Debt Repayment: Higher interest rates make it harder for emerging-market nations and companies to pay their dollar-denominated debts2. The worst-case scenario is a greater risk of default2.
- Current Account Impact: US dollar appreciations impact the current account, which captures the change in saving-investment balances of countries. As a share of gross domestic product, current account balances increase in both emerging market economies and smaller advanced economies, because of a depressed investment rate1.
- Policy Responses: In emerging market economies, fear of letting the exchange rate fluctuate and lack of monetary policy accommodation magnify the increase in the current account1. There, the income compression channel—where lower income leads to a decline in the purchase of imported items—plays a relatively bigger role1.
Emerging market economies with more anchored inflation expectations or more flexible exchange rate regimes fare better1. More anchored inflation expectations help by allowing more freedom in the response of monetary policy1.’