Fed rally to be short-lived; LATAM to underperform

The Fed delivered a dovish stance at its monetary policy meeting on Thursday which should provide a short-lived relief for EM. The Fed's concerns come down to two factors: China and the dollar. Here it is important to note that the Fed monitors the tradeweighted dollar. The CNY weighs 21% in the Fed's trade-weighted USD index and EM markets in total add up to around 47%. The recent weakening in EM currencies goes a long way in explaining the Fed's dovish stance on Thursday.

"However, we expect the rally in emerging market currencies to be short-lived for a number of reasons. Firstly, we still expect the Fed to raise interest rates in December as that is the time that the Fed will be able tick the boxes to get started. The countries which face the combination of large current account deficits and a large amount of USD debt are most vulnerable. In addition, the countries where the CA has deteriorated in recent years are most at risk, into which category fall BRL and COP. BRL, in particular, has already weakened a lot but we believe it has further to go. We also view high-beta currencies like TRY and ZAR as poised for further FX weakness. While CA balances are improving slightly in both countries they still run sizeable deficits and geopolitical risks are an added concern for the TRY", says Danske Bank.

Second, downside risks to China's growth remain and are likely to continue playing out in the coming months, weighing on sentiment towards emerging markets. Finally, substantial fragilities exist in a number of emerging market countries, including Brazil, Russia, Malaysia and Indonesia, where currencies are likely to remain under pressure even without Fed hikes and China risks. Hence, analysts are maintaining overall negative stance on EM currencies and have lifted forecasts on e.g. USD/BRL, USD/TRY and USD/ZAR.

The CEE currencies will remain the safe-haven of the EM world. Here external balances are solid, inflation is muted and the currencies are linked to the EUR which has become an anchor of stability. In addition, USD debt should be less of a concern in CEE than in LATAM.

"We believe that the CEE central banks have limited room for cutting rates and with the exception of the Czech central bank it is unlikely that they will directly intervene in the FX markets. Asian markets naturally remain vulnerable to the slowdown in China, but the currency has stabilised. In addition, recent intervention by the People's Bank of China in the CNH market which narrowed the CNH-CNY gap was a strong policy signal. This has mitigated the sell-off in Asia ex. Japan (AXJ) currencies and is likely to do so going forward", added Danske Bank.