The emerging markets lead the way in policy easing

The National Bank of Poland, made its first rate cut in this cycle earlier in the last week. 

Are there any early lessons that can be gleaned from the rate cuts that have occurred so far? The foremost observation is that the emerging market central banks that have eased policy have cut rates by more than the markets have been anticipating.

Mr. Steve Barrow, Head of Standard Bank G10 Strategy thinks this raises two issues. The first is whether G10 central banks will be more aggressive with their policy easing once rates start to fall. And the second is whether larger-than-expected rate cuts not only leave these emerging market currencies vulnerable, but also boosts the dollar against G10 currencies as well as emerging currencies.

In recent months, we have seen rate reductions in Chile, Brazil and Poland, and all produced larger rate cuts than the market was anticipating. The last of these, the National Bank of Poland, made its first rate cut in this cycle earlier in the week. The 75-bps reduction to 6% was far more than the 25-bps assumed by the market, while Brazil’s cut last month was 25-bps more than expected, as was Chile’s back in July.

Quite clearly it is too early to say that this is a trend, and that other EM countries hopping on the rate-cut bandwagon will do likewise, but we would not be at all surprised if this proves to be the case. If so, can we expect developed-country central banks to be more aggressive in their easing cycles than currently prices into the market? On one level, the answer seems likely to be “no”. For while these EM central banks have seen inflation rise sharply, and then fall, it does seem the case that G10 central banks have a more structural inflation problem because they have such tight labour markets. Therefore, we should expect them to proceed more cautiously when it comes to policy easing.

This being said, we should also bear in mind that G10 central bank officials are probably overplaying their future hawkishness right now because they don’t want to undermine the current fight against inflation by provoking speculation that rate hikes now will be reversed quickly and aggressively in the future. Once they are sure that inflation is under sufficient control we are likely to find that their hawkishness will melt away and rates will probably be cut more aggressively than the market currently assumes.

What about emerging market currencies? Won’t more aggressive rate cuts than anticipated undermine currencies? The answer here depends in part on whether the banks are thought to be paying fast-and-loose with inflation. It also depends on whether financial markets lean towards a risk-loving environment, or a risk-averse approach. If it is the latter, which Mr. Steve Barrow suspects is the case, right now, then these EM currencies could prove vulnerable as global investors will be more reticent to engage in purchases of their stocks and bonds, even if rate cuts seemingly make such investments more attractive.

Aggressive EM rate cuts could lift the dollar against not just these currencies, but also against other G10 currencies. One reason for this is that the rate cuts could lift risk aversion more generally if EM central banks are thought to be jumping the gun, and this could benefit the dollar against developed as well as developing currencies. In addition, there’s the possibility that US dollar-funded carry-trade unwinding takes place as EM countries start to cut rates, while the Fed leaves policy unchanged. At the moment it seems that the dollar is supported by both high risk aversion and high rates. More often, when risk aversion is elevated US rates are very low, like we saw in the early stages of the pandemic.

Of course, risk aversion is not as elevated now but Mr. Steve Barrow still feels that there’s sufficient caution amongst global investors to mean that any allegiance to the carry trade is quite flimsy, even if US rates were not as high as we see right now. Should US dollar-funded carry trades unwind, this could aid the US dollar against most G10 currencies as well as emerging market currencies.