The inverse relationship that exists between the strength of the USD and emerging market currencies is a worrying phenomenon in today’s global economy.

A September Rate Hike by the Fed will Turn the Screws on Weaker Currencies!

Dollar Strength is Expected to Increase before the Year is Out

Many an article has been written about the inverse relationship between dollar strength and the prosperity of emerging market economies. Nowhere is this more evident than in the exchange rates between the greenback and currencies like the South African Rand, the Turkish lira, the Brazilian real, the Russian ruble, the Argentinian peso and others. 2015 has been a year of strong and sustained growth for the USD, given solid fundamentals, decreasing unemployment, steady growth and a structurally sound economic recovery. This is in stark contrast to the economies of Asia, Europe and emerging market countries. Viewed in perspective, US bourses have fared particularly well against competing stock exchanges.

The Chinese stock market – the Shanghai stock exchange has come in for some serious tap in recent months, losing trillions of dollars. The Chinese authorities have implemented all sorts of regulatory measures (pouring in $1.3 trillion according to Peking Professor C. Balding) to stem the rout, by preventing investors with more than 5% holdings in companies from selling their shares for six months, suspending new IPOs, easing capital restrictions etc. That the Chinese have now allowed more free market activity for a recovery to take root is encouraging, but insufficient. Approximately 15% of Chinese households are invested in the stock market, meaning that its impact on broader Chinese society is less significant than the equivalent investments for North Americans, Australians or Europeans. However perception dominates over fundamentals and speculators have been going short on Asian stocks, commodities and emerging market currencies. As a case in point, the South African Rand briefly touched an exchange rate of 20 to 1 against the GBP and over 12.80 to 1 against the USD. Similar stories have been reported for major emerging market currencies around the world.

What is likely to happen with the Fed interest-rate hike?

The US dollar recently retraced some of its gains (during the first week of August), but comments from the President of the Atlanta Federal Reserve Bank quickly boosted dollar demand when it was mentioned that the likelihood of a September rate hike was very strong. The bad news for emerging market currencies such as the USD/ZAR, USD/BRL, USD/COP, the USD/MYR and others is that bearish prospects remain intact. The bulls of the foreign exchange market include the US dollar, the Japanese yen and the euro. The fact of the matter is that emerging market economies remain highly fragile. The reason for this is persistent commodity price weakness (oil, gold, copper) and the US dollar is making strong gains. With low oil prices, drilling, exploration and related activities become unprofitable, and much the same is true with gold, iron ore, copper and other mining-related activity.

If and when a Fed interest-rate hike takes place later in 2015, dollar demand will increase. The reason for this is simple: the US becomes inherently more attractive to foreign investors since the yield on dollar-denominated investments increases. Money moves from equities markets into Treasury notes, bonds and fixed interest-bearing accounts. At the same time, emerging market economies have to pay more of their own currency for every US dollar. This means that the cost of imports of raw materials into emerging market countries increases, and inflationary pressures come to bear on the local economy in an attempt to gain more US dollars for their exports. It’s a no-win for emerging market economies. During the current general economic malaise, investors with access to capital are likely to avoid the higher risk economies. With less demand for these emerging market currencies, foreign exchange rates become unfavourable.

Author’s Bio: Brett Chatz is a graduate of the University of South Africa, and holds a Bachelor of Commerce degree, with Economics and Strategic management as his major subjects. Nowadays Brett contributes from his vast expertise for the globally renowned spread betting and CFD trading company – Intertrader.