ORLANDO, Fla., Oct 4 (Reuters) - Brazilian markets are grabbing the headlines, leading investors' stampede back into riskier assets following the first round of voting in the country's presidential election.
The rally in Brazilian assets on Monday was breathtaking. The real soared more than 4% against the dollar, its biggest one-day rise in four years, its third largest in a decade, and 11th biggest since the currency was launched in 1994.
But there is a more fundamental reason why emerging markets more broadly could stabilize and even outperform in the fourth quarter: a softer U.S. dollar.
To be clear, the environment for emerging markets remains challenging as the Federal Reserve spearheads the tightening of global financial conditions. According to the Bank for International Settlements, non-financial dollar-denominated debt in emerging economies stands at $4.2 trillion.
Meanwhile, the message rammed home to investors from a raft of Fed officials is that conquering inflation remains their priority and they are not yet done raising interest rates.
But that is already baked into global asset prices, and has arguably been the main reason they have fallen so precipitously this year. Investors are looking ahead, and what they see are conditions that suggest the dollar loses some of its steam.
That may already be underway. The dollar's value against a basket of major currencies has fallen five days in a row. That doesn't sound like much, but it is the longest downturn in over a year.
Its value against emerging market currencies may also be peaking.
U.S. inflation expectations are falling steadily and significantly, consumer and market-based measures show. Breakeven inflation rates across the two- to 20-year spectrum on Friday slumped to 2.15%, the lowest in a year and a half and within sight of the Fed's 2% medium term target.
U.S. Treasury yields and implied interest rates have fallen by as much as 50 basis points since the Fed's 75 basis points rate hike last month, and traders are cooling on the idea that it will deliver another 75 basis points later this month.
This is welcome news for emerging market investors and in particular EM policymakers, an increasing number of whom have intervened in foreign exchange markets recently to support their currencies.
From India to South Korea, Chile to Brazil, emerging market central banks have sold billions of dollars for domestic currency recently. JP Morgan analysts say emerging economies' FX reserves are dwindling at the fastest pace in two decades.
A softer dollar eases that pressure.
Steven Englander, head of G10 FX strategy at Standard Chartered, notes that dollar strength is broadly negative for the world as "added credit risk premia, potential debt servicing issues and risks of diminished liquidity add to risks of financial market disruption."
Again, a softer dollar eases those pressures.
Given how grim the first three quarters of the year have been, investors may be tempted to stay hunkered down for the fourth. Alternatively, it may be the ideal time to put some chips back on the table and reduce those losses.
The JP Morgan's emerging government bond index rose 0.7% on Monday, its biggest rise in almost two months. There's more room for that to continue too, with the index still down more than 23% year to date.
The same goes for equities. The MSCI Emerging Market equity index is down 29% so far this year in dollar terms, underperforming the MSCI World, which is down 25%.
According to Bank of America's September fund manager survey, a net 60% of those polled said they are taking lower-than-normal risk levels, up from a net 47% in August and the highest in over 20 years of the monthly survey.
BlackRock, the world's largest asset manager with $8.5 trillion under management, is overweight emerging market debt because many EM central banks are far more advanced in their tightening cycles than their developed world peers.
Strategists at TD Securities agree. They reckon many emerging countries' sovereign bonds have sold off so much that they are now "very cheap", with spreads at "extreme levels".
"These are opportunities that may start to fade soon," they wrote on Tuesday.
(The opinions expressed here are those of the author, a columnist for Reuters.)
Related columns:
In reverse currency war, there's only one winner (Sept. 23)
'Peak super hikes', even if not peak rates (Sept. 9)
(Reporting by Jamie McGeever; Graphics by Marc Jones; Editing by Jonathan Oatis)
