CME - High Inflation and a Strong U.S. Dollar – For Now the Only Way is Up
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As 2022 is well overhalfway through, markets may be feeling like the COVID-19 theme hassubsided after the two-year peaks and troughs of the pandemic, but asalways new challenges arise and lead the way for more potentialvolatility. Inflation is the ‘flavor of the year’ as economiesswing into the aftermath of the pandemic with central banks tighteningmonetary policy to manage dips in their own currencies to curb therise in inflation. This theme is particularly challenging for emergingmarket economies, as is the increasingly stronger U.S. dollar. Allprevious emerging market fallouts were linked to dollar strength, andas the need to steer off dips in currencies occurs, central banks haveturned to tightening their monetary policy. This has led the WorldBank to forecast just a 4.6% expansion for emerging economiesthis year, compared with an earlier 6.3% prediction, and theInternational Monetary Fund expects inflation to average 8.7% inemerging markets this year - around 2.8% higher than projected at thestart of the year in January.
Why does a stronger dollar lead to a strugglefor emerging market economies?
Firstly, a strong USD often starts to depressglobal trade growth as it is the ‘invoicing’ currency of the worldand holds the most purchasing power. This means that when the USDappreciates, other currencies essentially depreciate, making the worldpoorer and less able to engage in trade. It also makes countries thathave USD denominated debt less creditworthy, as it makes it harder forthem to purchase the U.S. currency to manage their debts. Furthermore,it is likely more unfavorable for China. This can lead to anobstructive knock-on effect for emerging market countries due to theirlinked supply chains and commodities demand. Finally, the strongerdollar is also more likely to cause inflationary upward pressures foremerging markets because they typically purchase their raw materialsin USD.
Source: Bloomberg
Commodity appreciation – who reaps thebenefits?
Theother complication for emerging markets is the simultaneous rise incommodity prices, which are likely to persist for some time given thecurrent economic landscape. Emerging markets are experiencing thelagged effects of higher oil prices, elevated food prices, and higherimport prices from currency depreciations. As the demand for productsincrease, so does demand for the materials used to produce them, whichresults in higher commodity prices. Commodities are also heavilyrelated to demand and supply dynamics and compared to other inflationprotection assets like TIPS (Treasury Inflation Protected Securities),they tend to offer higher returns.
Rising commodity prices hurt many emerging markets,but others stand to benefit. Commodities are a critical source ofexports and revenues for many emerging economies, and more than halfof the world’s poor reside in commodity exporting countries ( WorldBank ). The reliance on commodities is particularly high foroil exporters such as Brazil, Mexico, and Russia, and on metal andagricultural exporters such as South Africa and Chile.
Commodity prices undergorepeating cycles, and on average, from peak-to-peak, cycles lastalmost six years. For industry intensive commodities, such as copperand aluminum, prices remain in the same phase of the cycle for 80% ofthe time. According to the WorldBank Group’s Flagship Report from January 2022, thissynchronization was reflected statistically in a common factor that onaverage accounted for roughly 15-25% of price variability for energyand metals, but only 2-10% of price variability for agriculturalcommodities and fertilizers.
As the chart below highlights, commodity pricesbounced in 2021, partly correcting for the sharp decline during the2020 Covid pandemic, and this rise has continued into 2022.
Source: World Bank
Global trade, supply disruptions, and climate related eventsare areas that can amplify commodity price movements and their role ineconomic activity, therefore understanding the movement in commodityprices can help manage financial stability and both fiscal andmonetary policies.
Taking inflation out of the mix, both commodities and theircorrelated currencies still need risk management
The changing value of acurrency against the USD can have a substantial effect. Whether acountry is the importer or the exporter, will dictate either abeneficial or adverse outcome from currency movements.
For example, China isthe largest participant in the global Copper market, therefore theexchange rate between the RMB and the USD plays a key role in thistrade. China is the largest producer of refined Copper but much of theore and concentrate is imported, and as the Copper market tradesprimarily in USD, how the value of the Chinese renminbi (RMB) changesversus the U.S. dollar significantly impacts the economics and outcomeof the trade. The volatility in the USD/OffshoreRMB (CNH) creates variation in the price for USD and CNHpriced Copper markets. However, CME Group offers futures contracts onthe Chinese Renminbi, which can be used to manage this FX exposure viahedging.
The U.S.is the largest producer and exporter of corn and Mexico is the largestimporter from the U.S. Therefore, as the importer, Mexico is moreexposed to the exchange rate risk between the U.S. dollar and theMexican peso (USD/MXN). If the dollar strengthens, the Mexicanimporters are adversely affected as the corn becomes more expensive,but vice versa if the dollar weakens. CME Group offers both futuresand options contracts on the Mexican peso that can be used tomanage this kind of FX exposure while the CBOTCorn futures contract is the global benchmark for the market.
Similarly, theSouth African rand is linked to precious metals prices with SouthAfrica being an exporter and although their price is often correlated(e.g., higher metals prices can often lead to a stronger rand), thereis still the exchange rate risk between the rand and the U.S. dollar,as the metals are primarily priced in USD. CME Group offers both futuresand options contracts on the South African rand that can beused to manage this kind of FX exposure.
Commodity and derivative exchanges around theworld enable the trading and risk management of both currencies andcommodities. CME Group offers a variety of derivatives contracts tomanage these risks together or as separate products.
As demonstrated, thedirection of the USD heavily impacts emerging market currencies andexchange rate risk, particularly for imports and exports. While theUSD stays strong compared to other currencies, it will continue tohold the purchasing power and make it more expensive for emergingeconomies to engage in trade. High inflation also adds to the strugglefor emerging markets with central banks turning to tighter monetarypolicy to assist with the rise in prices. Inflation will likelycontinue to be the one to watch in 2022.
As the world'sleading derivatives marketplace, CME Group https://www.cmegroup.com/)enables clients to trade futures, options, cash and OTC markets,optimize portfolios, and analyze data- empowering market participantsworldwide to efficiently manage risk and capture opportunities. CMEGroup exchanges offer the widest range of global benchmark productsacross all major asset classes based on interest rates, equityindexes, foreign exchange, energy, agricultural products and metals.The company offers futures and options on futures trading throughtheCME Globex® platform, fixed income trading via BrokerTec and foreignexchange trading on the EBS platform. In addition, it operates one ofthe world's leading central counterparty clearing providers, CMEClearing.
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