Degrees of separation: Re-examining the relationship between EMD and the dollar

Old assumptions on the traditional link between emerging market debt and the greenback are being challenged, writes Liam Spillane, Head of Emerging Market Debt at Aviva Investors.

For investors, it can be tempting to rely on established relationships in markets. In the last decade, for instance, market rallies have often been a function of central bank stimulus, while sell-offs occurred when concerns became elevated that the policy environment would be less accommodating.

Historically, a strong correlation has existed between the US dollar and emerging markets. Investors have generally been able to rely on the following scenario: when the US dollar rose, trouble loomed for emerging equity and debt markets. A veritable Pandora’s box would be opened, consisting of some, or all, of the following: capital outflows, rising debt ratios, higher inflation and weaker domestic currencies creating a greater need for more restrictive monetary policies. When the dollar fell, the lid of the box would snap shut, and emerging equity and debt markets generally appreciated due to the attractive structural properties of developing nations and the resultant capital inflows.

However, as with all relationships, there is ebb and flow and factors driving assumed connections can fray or intensify. While not seeking to call a long-lasting or permanent breakdown in the correlation between movements in the dollar and emerging markets, recent developments have, in our opinion, suggested a weakening of the hold that the former has over the latter.

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