Strategy

Higher U.S. Rates Will Weaken Emerging-Market Currencies

A December rate hike by the FOMC is almost a certainty. Here's how it will affect U.S. profits.
Natasha LalaNovember 23, 2016
Higher U.S. Rates Will Weaken Emerging-Market Currencies

Few things are predictable in finance. Yet almost no one would be surprised by a U.S. interest rate hike in December, especially after the Federal Reserve Open Market Committee noted that inflation expectations and economic growth were finally in the right place.

Such a move would cap a year’s worth of indecision, which has greatly influenced the appetite for global currencies. Indeed, as the year progressed and the odds of multiple increases from the FOMC fell, emerging-market currencies like the Brazilian real and South African rand benefited from a higher risk appetite among investors.

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Now that a rate hike seems a more plausible near-term scenario, emerging markets could see their high-flying currencies come crashing to earth. The reason is that higher interest rates typically attract investors seeking bigger yields; to accommodate this, money flows away from riskier currencies.

The Effect on Cash Flows

There are upsides and downsides for U.S. companies. A stronger U.S. dollar means that goods and services procured abroad will cost less. Depending on the global footprint, supply chain costs could decrease and provide a minor increase to the profitability of goods produced at the end of the chain.

Natasha Lala

Natasha Lala

However, companies that are headquartered in the U.S. and rely on demand in emerging markets may be squeezed. Consumer goods companies, like Procter & Gamble and Pepsi, have reported revenue losses due to foreign exchange-rate fluctuations for the last few years. Some of these firms are already factoring the impacts of a U.S. rate hike into future revenue forecasting.

For companies based outside of the U.S., the news is just as mixed. Those companies that export to the U.S. can expect greater revenues (after repatriation into their local currencies) and a higher appetite for their products. Companies that purchase U.S. goods as part of their supply chain, however, are likely to see their costs go up.

It’s also worth noting that an interest-rate hike may make it difficult for US companies to issue bonds. The cost of currency hedging against the dollar has grown expensive in recent months. Per analysis from Bloomberg, this growing cost coupled with higher interest rates would make U.S. corporate bonds less appealing for foreign investors, who have been the biggest buyers of such assets in 2016.

Currencies to Watch

After the last federal funds rate hike in December 2015, macroeconomic expert Eswar Prasad stated that the move would leave many emerging markets with little choice for an appropriate economic response other than “[pushing] through essential reforms.” The countries that have stalled on improving their economic fundamentals stand to be the most sensitive to a U.S. rate increase.

Two currencies stand out in particular:

  • Brazilian real. In spite of its appreciation year-to-date, the real is still in a precarious place. Companies that purchase Brazilian commodity exports, like soybeans and sugar, stand to benefit. Many international companies have sizable operations in Brazil, despite a retreat of sorts in 2016. Because a rate rise would make it more difficult for Brazilians to buy domestic goods using credit, some companies could expect further impact to revenues.
  • Russian ruble. The currency has strengthened over the past year in spite of falling oil prices and two rate cuts from the Bank of Russia. As is the case with many other nations, Russia is keen to devalue its currency further in the year ahead. Falling rates, a dampened appetite for risk, and a U.S. rate increase could pull some of the flow of money away from Russia and make the currency much weaker against the dollar.

A 0.25% increase to the federal funds rate may not seem like a spectacular one, yet such a move will have a notable effect on the buying and selling of goods. For international companies, supply chain financing, revenue forecasting, payments, and profitability expectations will all need to be adjusted in some fashion.

Natasha Lala is managing director at OANDA Solutions for Business, a provider of currency data and FX services.