Key Takeaways:
Geopolitical risk in the Middle East is driving a flight to safety, pushing Asian currencies lower against a strengthening dollar.
Most Asian currencies weakened against the dollar on Monday as renewed military exchanges between the US and Iran triggered safe-haven demand, compounding pressure from a hawkish Federal Reserve.
"The combination of escalating Middle East tensions and a more hawkish Fed creates a powerful headwind for emerging-market currencies," said Philip Fielding, a portfolio manager at Fidelity International in London.
The dollar is on track for its best monthly performance in a year, while the US five-year yield remains more than 60 basis points above its level before the Iran conflict began. Brent crude traded near $71 a barrel, down from conflict peaks but still elevated enough to pressure oil-importing Asian economies.
The renewed geopolitical risk threatens to reverse gains from the US-Iran peace agreement earlier this month, with investors now pricing in a prolonged period of elevated uncertainty that could keep capital flowing out of emerging Asia and into dollar-denominated assets.
A Dual Shock for Emerging Markets
The latest escalation marks the fourth consecutive day of heightened hostilities, with the US and Iran exchanging direct threats while Gulf allies including Saudi Arabia and the United Arab Emirates intercepted drones believed to originate from Iranian territory, according to reports. The Strait of Hormuz, through which about 21 percent of global oil trade passes, remains a focal point for potential supply disruption.
The geopolitical shock arrives just as emerging-market bonds were beginning to benefit from falling energy prices after the US-Iran interim peace agreement. Goldman Sachs strategists including Kamakshya Trivedi and Danny Suwanapruti wrote in a June 18 note that "EM local rates are now fighting a new adversary — a hawkish Fed," shifting the primary risk factor from oil markets to US monetary policy.
The correlation between US five-year Treasury yields and emerging-market bonds has risen sharply this quarter. The rolling 30-day correlation with Latin American bonds climbed to 0.49 from 0.10 at the end of February, while the correlation with emerging Europe, the Middle East and Africa rose to 0.43 from 0.03. In Asia, the correlation edged up to 0.09 from 0.04.
Central Banks Cautious on Easing
The stronger dollar is making emerging-market central banks more cautious about signaling policy easing, limiting the scope for local-currency bonds to extend their gains. Citigroup strategists led by Luis Costa wrote on June 18 that "central banks are likely to remain cautious in signaling all clear which could keep risk premia elevated in EM local currency."
Countries relying more heavily on foreign capital inflows, such as Turkey and Colombia, face the greatest vulnerability to a broad tightening in financing conditions, Fielding said.
Not all investors expect higher US rates to derail the asset class. "If tighter policy reflects stronger growth, the implications for EM local currency debt would likely remain constructive overall," said Ward Brown, a fixed income portfolio manager at MFS.
The durability of the US-Iran peace agreement remains a key variable. A lasting reduction in tensions would help keep oil prices contained and preserve room for central banks to ease, while any renewed conflict may quickly reverse those gains. "The durability of the peace deal is not yet certain, so we continue to expect headline-driven two-way volatility in markets," said Hakan Aksoy, a senior emerging-market portfolio manager at Amundi.
Investors are now watching China's manufacturing PMI release, along with inflation reports from Indonesia, South Korea, Poland and Turkey, for signs of how the dual shocks of geopolitical risk and a hawkish Fed are filtering through to domestic economies.
This article is for informational purposes only and does not constitute investment advice.
