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Dovish Fed & ECB – Implications for Emerging Markets currencies

In response to the recession in 2007, the US Federal Reserve immediately responded by using its monetary policy instruments – lowering the federal fund rate from 5.25 to 0.25 by the end of the year 2008 and quantitative measures through bond buying.

Once the federal fund rate effectively hit the zero level by the end of 2008, the Federal Reserve engaged in unconventional monetary policies to provide further stimulus. The Federal Reserve purchased long-term Treasury Bonds, with the main focus being on Quantitative Easing (QE), lowering the long-term interest rates and encouraging economic activities.

Massive capital flows were witnessed into the Emerging Market (EM) economies since the Federal Reserve started its QE policy in 2008 and as a result, their currencies have appreciated substantially. These developments had a significant financial and macro-economic impact on these economies.

A lower fund rate and an economic stimulus have impacted the Emerging Markets economies, especially Chile, Colombia, Brazil, India, Indonesia, Malaysia, Mexico, Peru, South Africa, the Republic of Korea, Taipei, China, Thailand and Turkey. QE and lower rates led to an appreciation in the domestic currencies of EM’s against the US dollar, decreased long-term bond yields and increased the stock prices in these countries.

Figure: US unemployment rate is decreasing and inflation is cooling make the best case for Fed to cut interest rate (Source: Abans Research and Bloomberg)

The US Federal Reserve hinted at cutting the interest rates later this year on account of increased economic uncertainties post-trade war and lukewarm inflation. Two rate cuts are projected to take place in 2019 while the Fed is also planning to cut the target rate for 2020 and 2021. This action will be a major factor in influencing the currency moves within the short to medium term, along with the ECB plan to boost the bond-buying program, which will enhance liquidity in the system. We have seen an initial reaction in terms of the gold rally this week and further upside can be seen in riskier assets in the medium term.

Image62162019Figure : RBI takes necessary measures as Fed goes for either a rate cut or an increase (Source: Abans Research and Bloomberg)


Figure : Source – Abans Research and Bloomberg

This dovish monetary policy from the Fed and ECB has turned positive in the last rate cut cycle and is expected to have a positive impact on India as well. We can see good inflows from the Foreign Portfolio Investors (FPI’s).

Image82162019Figure: Indian Nifty50 index rallied and the currency remained in a range while Indian exports declined once the Fed rate approached Zero level and US exports started recovering (Source: Abans Research and Bloomberg)

Currency appreciation has its own negative impact in terms of lower exports, low output and flat consumer prices in emerging markets in the long term. In light of the appreciation of exchange rates in the Emerging Economies, the US will benefit with an improvement in financial conditions, as there will be an increase in demand for American products which can further improve their exports. Central banks of EM’s have to be cautious and take necessary actions to prevent excessive appreciation in the currency. On the domestic front, we can see the Reserve Bank of India (RBI) soon in action; other central banks may also take necessary actions in the near future.