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Emerging market currency rally weakens in August; Turkish lira hits record low

Emerging market currencies rallied for a fourth consecutive month in August although some failed to sustain the momentum gained in July as their appeal as carry trade targets continued to wane due to the unprecedented environment of aggressive monetary stimulus amid the coronavirus crisis.

The MSCI International Emerging Market Currency Index, which measures the performance of 26 currencies from emerging economies relative to the U.S. dollar, increased 0.9% in August following a 1.4% rise the previous month. The index "has run out of steam" as the outlook for global growth recovery "got cloudier from the resurging virus numbers worldwide," according to Win Thin, global head of currency strategy at Brown Brothers Harriman.

Thin also said record low policy rates across emerging markets are the "final nail in the coffin" for carry trade, a strategy in currency markets that involves borrowing in a low-yielding currency to buy a higher-yielding one in an attempt to capture the difference between rates.

"Forward guidance from virtually every central bank suggests interest rates are not going up anytime soon. As such, investors will have to get used to this new normal of extremely low carry across most currencies," Thin wrote in an Aug. 20 note.

"When carry is pretty much the same everywhere, we think investors will have to go back to the fundamental stories for each currency," Thin added. "Which countries are growing relatively faster? Which ones have transparent policymaking and predictable investment environments? We believe these sorts of factors will drive currencies for the time being, not relative interest rates."

Fifteen of the 21 emerging market currencies tracked monthly by S&P Global Market Intelligence traded in the green in August, with the Indian rupee and South African rand leading the pack with gains of 2.5% each against the dollar.

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The rupee rallied after rising inflation prompted India's central bank to unexpectedly keep rates steady at its Aug. 4-6 meeting. Minutes of that meeting also showed hawkish comments from policymakers, which suggested that the Monetary Policy Committee "has already front loaded cuts in the policy rate."

Meanwhile, the decline in the number of new coronavirus cases in South Africa lifted the rand, which also got a boost from the easing of lockdown restrictions during the month. "The move towards normalizing the economy in the African country hit hardest by COVID-19 infections stimulated rand purchases by investors seeking alternatives to low dollar yields," wrote Murega Mungai, trading desk manager at African currency trading solutions firm AZA.

Four Latin American currencies posted losses in August as they were weighed down by negative investor sentiment towards the region, which became the new epicenter of the coronavirus pandemic in previous months, according to Gustavo Rangel, ING chief economist for Latin America. "Moreover, the economic impact of the pandemic is likely to exacerbate the region's existing macro fragilities," Rangel said in a note. The Brazilian real fell 4.8% last month while the Chilean peso and Argentine peso dropped 3% and 2.3%, respectively.

The Turkish lira was the worst-performing emerging market currency in August, retreating 5%. The currency touched new all-time lows during the month, closing as weak as 7.40 per U.S. dollar at one point, according to S&P Global Market Intelligence data.

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Having lost about 19% of its value this year, the lira remains under pressure amid concerns over elevated inflation, a depletion of Turkey's foreign exchange reserves, a sizable current account deficit and weak monetary policy credibility, factors that drove Fitch Ratings to lower Turkey's ratings outlook to negative from stable in August.

"The Turkish government's policy stance and the positioning of the central bank are not helping matters right now," Dennis Shen, lead analyst for Turkey at Scope Ratings, wrote in an Aug. 13 note. The rating agency downgraded Turkey's credit ratings to B+ from BB- in July.

Shen does not expect Turkey's central bank to deliver an outright interest rate hike to defend the lira given President Recep Tayyip Erdoğan's preference for low rates. The bank left rates unchanged in August but vowed to continue with backdoor liquidity measures to support macrofinancial stability.

"A significant increase in rates would be helpful in stabilizing current exchange rate devaluations, although such a hike would come at risk of undermining Turkey's fragile economic recovery from coronavirus-linked contraction," Shen said.