The Iran war has dragged on for longer than markets had anticipated in the spring, which is creating a challenging backdrop for emerging market currencies.
The signing of the memorandum of understanding in mid-June promised a path to a formal end to hostilities and a reopening of the Strait of Hormuz. Peace talk shave stalled, however, and hostilities have resumed,triggering a fresh move higher in oil prices, an increase in inflation expectations and an upward repricing in central bank interest rates. So far, the reaction in FX has been reasonably contained,although we would expect to see a return of risk aversion the longer the current impasse continues.
Our world view remain predicated on an eventual peaceful outcome to the war.We largely view Trump’s latest outbursts as leverage-building ahead of peace talks, and all part of the now-familiar rhythm of truce, collapse and escalation that has defined the war.Structural sticking points remain,however, that cannot be dissolved through bluster alone,and it will be very tough for Trump to orchestrate a successful reopening of the Strait of Hormuz without Tehran assuming de facto control.
Layered on top of the geopolitical risk premium is the implications of the renewed tensions for monetary policy.In light of the hawkish policy shift at the Federal Reserve’sJune meeting, we have revised our dollar forecasts higher against a handful of currencies, in part as we think that this signifies a subsiding in US institutional degradation risk. Even so, we see LatAm FX as reasonably well placed within this backdrop given that several countries in the region are both net beneficiaries of the renewed rise in oil prices, and offer attractive carry trade opportunities due to high real yields.
For the most part, the Latin American currencies have held up well of late, with the Brazilian real, Mexican peso and Peruvian sol all trading largely unchanged on the dollar since our last update. The Colombian peso (+27% YoY)has been the standout, a combination of the electoral outcome, a jump in oil prices and aggressive hiking from the Central Bank of Colombia, while the Chilean peso (+1%YoY) has struggled amid a soft growth performance and high exposure to the energy spike. We see gains for most of the LatAm currencies ahead. Valuation and macroeconomic fundamentals remain supportive, though a hawkish Fed repricing or a sharper pullback in commodity prices stand out as the key risks to this view.
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