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Emerging markets ‘going to be struggling’ amid Fed rate hikes: FX strategist

ING FX Strategist Francesco Pesole joins Yahoo Finance Live to discuss what's driving the U.S. dollar, the outlook for the Japanese yen and Chinese yuan, and how Federal Reserve rate hikes will affect emerging markets and their currencies.

Video Transcript

- We've got to shift gears because Tuesday's hotter than expected inflation report stoked fears of a more aggressive rate hike scheduled from the Federal Reserve. And then as interest rates continue to climb, so does the US dollar, with the US dollar index, the so-called Dixie, recently hitting a two-decade high. The implications of a strong greenback are far and wide. And let's break it down with ING FX strategist Francesco Pesole And let's start with the dollar here. We are at multi-decades highs, strengthenings versus the euro, versus the yen itself going back to the '90s. What are we to make of this?

FRANCESCO PESOLE: Well, we know the drivers of this. Obviously, we've seen the Fed being hawkish. And that has been kind of the first engine of dollar strength over the past few quarters. But then, obviously, the energy crisis in Europe. And that appears to be at the moment the biggest drivers simply because growth differentials are becoming more relevant for FX.

And when you look at euro-dollar, even though the gap between the Fed and the ECB has closed a bit and euro-dollar just looking at the two-year rate differential should be trading higher. Well, the energy story in Europe and how it's affecting a large part of the world and in a way is kind of keeping markets very reluctant to jump away from US assets to European assets. All this is really at the moment what's driving dollar strength.

- And let me ask you about Asia then because we've seen a tremendous weakening of the yen, not only against the US dollar, but other currencies as well. And we've seen this before. We know how this movie ends potentially. A lot of times at the end of these moves, there is a huge rush into the yen as the market's price an eventual move by their central bank. We have interest rate differentials. We also have haven flows. Should we be concerned about the move into the yen now and any potential reaction by the BOJ, the Bank of Japan?

FRANCESCO PESOLE: Yeah. We think the markets are probably underestimating the risk of FX interventions by the Bank of Japan. If you look at the implied volatility on dollar-yen, this should be trading much higher if markets were seriously considering the high risk of FX interventions. Today was really interesting because the yen had a-- sorry, the Bank of Japan spoke with traders and dealers and asked for a price check. And that's normally what happens before an intervention.

Now, this could be simply a way to test the market. And we did see dollar-yen trade lower after that news this morning. But surely the risk of interventions are quite high at this point. The matter with intervention is always if they work or not. And if market's potential is not looking at the risk of a BOJ intervening that seriously, there's also a chance that they are expecting in a way FX intervention, but they're not expecting them to work out that well.

- Well, and let me stick in Asia there for a second. I'm looking at the YFi Interactive. I'm looking at the yen versus the Chinese yuan. And it is down 24% over the last two years. A longer term chart shows we just broke through what could have been support there. Difficult to see on the scaling here. But nevertheless, what are the odds that the Chinese central bank, the PBOC, has to do an intervention against the yen or even the US dollar as well?

FRANCESCO PESOLE: Well, when it comes to the PBOC, it's a different story because the PBOC obviously issues every day it's fixing. And this is the preferred way of, in a way, managing its currency. And, surely, they had to accept a weaker yuan on the back of lockdowns.

And, obviously, the economic picture in China that has deteriorated quite a lot. We think when it comes to the yuan, there's always this fine line between having a strong currency to try and insulate China from high energy prices and having a weak currency to support growth. At the moment, it looks like the PBOC might tolerate a slightly weaker currency to support growth. But it's much more uncertainty. And, obviously, the fact that the PBOC intervenes on a daily basis means it's a little harder to predict a larger FX intervention.

Well. And let's get to some emerging markets, some true emerging markets. You could take, for instance, some of the South American markets from the Argentine peso to the Brazilian real. We've seen some of these under pressure recently. What's your take on EM?

Well, EM is naturally going to be struggling in an environment where the Fed continues to hike aggressively. That's just a natural consequence. And we've seen it throughout history. And at the moment, I think until we get to the point where the Fed truly starts to send some signals that it's pivoting towards a less hawkish stance, EM currencies will remain in under a certain degree of pressure.

And really in order to see some big recovery there, you need to see the dollar starting to come lower. And then you have local stories. And that's going to be quite relevant. I'm just thinking of the Brazilian real, obviously, with the election story. And that's a major risk there. And so it's a combination of these two factors. We think into year end, emerging market currencies still don't look too good.

- We have to leave it there. But appreciate you stopping by. ING FX strategist Francesco Pesole