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Emerging market currencies slide when the US raises rates, but the won defies gravity

A rise in US interest rates, when it finally comes, will be terrible news for emerging market currencies. In an uncertain world, historical precedent tells us that this relationship, at least, can be taken as read.

Except, of course, that it is not true, at least when it comes to the South Korean won.

The well-rehearsed argument is that rock-bottom policy and market interest rates in the developed world have unleashed an unprecedented wave of portfolio investment into emerging markets as investors desperately seek a semblance of yield.

When the US Federal Reserve finally starts to change course — possibly as soon as September — these flows will reverse, leading to widespread selling of emerging market currencies, which will tumble in particular against a strengthening US dollar.

The well-publicised “taper tantrum”, when emerging market bond yields shot up in 2013 simply because Fed chairman Ben Bernanke merely mulled the prospect of slowing quantitative easing, let alone actually raising rates, is cited as Exhibit A in this debate.

Analysis of previous Fed tightening cycles by Standard Chartered does illustrate a broad, if far from uniform, correlation between rising US rates and falling EM currencies.

But one line stands out like the proverbial sore thumb — the counter-intuitive behaviour of the South Korean won, which StanChart finds has historically strengthened in unison with a rising Fed funds rate.

A closer inspection reveals the won is, well, wonky, when it comes to its unusual reaction to events in Washington DC.

During the 2004 to 2008 Fed tightening and loosening cycle, the won/dollar exchange rate was very tightly correlated with US interest rates. The won rose 18 per cent as the Fed raised rates by 425 basis points, only to slide 30 per cent as US rates were slashed from 5.25 per cent to 0.25 per cent.

Likewise, when the Fed raised rates between 1999 and 2000 the won strengthened against the dollar, only to hand back many of these gains when the US started cutting rates aggressively in 2001.

The won also rose against the dollar during the 1992-94 US rate rise cycle having surged 23 per cent against the greenback between 1986 and 1989, as the Fed raised rates by almost 400 bps.

So why does the currency behave in such a counter-intuitive manner?

Marios Maratheftis, chief economist at StanChart, believes he has the answer. Fed rate rises come when the US economy is expanding. This benefits Korea’s export sector, bolstering industrial production, the current account surplus and ultimately the won.

“Korea is more exposed to the economic cycle of the US as an export market, and is less exposed to the financial market,” he says.

Such an explanation sounds fairly straightforward, although it should be noted it does not seem to apply to any other major emerging market currency.

If true, this finding has some important ramifications. StanChart notes that in the past nine months, several members of Seoul’s monetary policy committee have raised concerns about the narrowing spread between US and Korean interest rates, which they fear will make South Korea less attractive to investors, potentially triggering disruptive capital outflows.

StanChart argues that the Bank of Korea “does not need to be too concerned about the impact of Fed rate hikes in 2015 and can maintain its dovish stance”.

More broadly, this analysis might suggest emerging market investors should load up on Korean assets, assuming of course they believe the Fed is readying a rate rise.

StanChart is a little circumspect on this, however, noting that the US now accounts for just 12.2 per cent of South Korea’s trade, down from 20.5 per cent in 1999, as China’s share has risen. This suggests a US recovery might provide less of a boost to the Korean economy than in the past.

Others are also unconvinced. Ilan Solot, emerging market currency strategist at Brown Brothers Harriman, admitted to being “surprised” by the historical relationship between US policy rates and the won.

Mr Solot does not expect a significant sell-off in emerging market assets when the Fed does start to normalise rates. However, in the event there is a sell-off, he regards the won, alongside the equally liquid Brazilian real and Mexican peso, as the “classic proxies” that could be sold by investors struggling to cut their exposure to less liquid Indonesian, Malaysian and Philippine assets.

More broadly still, StanChart’s analysis suggests that previous Fed-induced EM currency sell-offs have typically righted themselves within 12 months, even in the worst-hit countries.

“The big impact happens six months after the shock [of rising rates],” says Mr Maratheftis. “Within a year the shock is absorbed, these currencies more or less recover.

“Even in Turkey, which has a violent move [in StanChart’s model], 12 months later [the currency] is back to where it was.”

 original source: http://www.ft.com/intl/cms/s/3/cba30284-20a3-11e5-aa5a-398b2169cf79.html#axzz3f7dsBx22

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