Upcoming Currency Issues in Emerging Markets

The past few weeks had been the most volatile in decades, with financial markets rattled by a sudden global economic stop triggered by the coronavirus outbreak. With many countries enabling state of emergency and with complete lockdowns in affected areas, the economic prospects for 2020 are very negative. Some analysts predict a depression-like period ahead, but in reality, no one knows what will happen, until humanity will find a way to contain the pandemic.

What happens with emerging markets?

As with other periods of economic uncertainties, the US dollar had been the best-performing currencies. Although various traders that it will collapse with the Fed cutting rates aggressively, it outperformed all major currencies, and the DXY (the US Dollar index) surpassed the 100 mark. Since the US dollar is the global reserve currency, we must understand that aside from the debt existing in the US, there is a huge money market (for US dollar) on a global scale.

Companies and governments had been pilling up on dollar-denominated debt after the 2008 financial crisis (when the DXY was trading around 75 and the Fed’s interest rate was near zero) and now that money markets have frozen, they have to find ways to refinance that debt. Some estimated say that there are more than $14 trillion on dollar debt outside the US and if we assume that the average interest in around 2%, then we end up understanding that there is a constant demand for dollars.

A self-reinforcing pattern

Since emerging countries need dollars in order to finance that debt, they exchange their own currency into US dollars, leading to massive flows towards the global reserve currency. At the same time, not all the debt is paid back all at once, so emerging countries have to constantly sell their currency for the dollar.

In the short-term horizon, the Federal Reserve had conducted swap operations with most of the major central banks, in order to ease the demand for the dollar. At the same time, it started an “open-ended” quantitative easing program, that aims to support the markets.

What forex traders need to understand is that the “dollar trade” might be far for ending and in the meantime, they should trade momentum breakouts strategies, among others, and avoid falling into the trap of listening to what other people think. The price will tell us everything we want to know. There’s no point in taking positions against the dominant order flow.

 

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