There is a consistent thread of discussion regarding the impending Fed rate hike and its impact on various markets, which are known to front-load the expected returns impact of the entire series of hikes in the first hike. Such forward expectations of relative value are common, as a change in interest rates impacts the expected returns not just in bonds, but any market that considers U.S. Treasuries as one barometer of return of "safe" assets. When return of safe assets rises, a value adjustment across the risk curve should be expected. What a higher U.S. interest rates does is increase returns expectations of “safe” investments, making them more attractive relative to risky alternatives, and thus change the expectation of acceptable returns. At times this can get overdone, or mis-analyzed, which is where a recent Source Multi-asset research piece comes in play.

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U.S. Fed tightening being considered as reason for sinking emerging market currency values

The recent sharp decline this month of emerging market currencies is being attributed to a significant degree to the forthcoming potential for Fed tightening. But this rational is not the only issue at play, report authors Paul Jackson and Andras Vig observe. To understand the real issues in emerging markets, investors should look past the shiny gloss of a Fed rate hike explanation and instead focus on commodities.

Emerging markets with perpetual exposure to commodities have sinking currencies. Those nations with lighter commodity exposure, when isolated from the emerging market currency pact, have not experienced the same degree of a drop. In other words: don’t make a blanket statement that the drop in emerging market currencies is due to an impending U.S. rate rise. Compare traditional emerging market currencies such as Brazil, for instance, which is currently down to 12 year lows for a variety of reasons, with emerging markets such as the Czech Republic, without the same degree of commodity production dependency and one sees a difference. Most commodity dependent emerging market currencies are failing badly, while those rare emerging markets not dependent on commodities in a significant way are prospering.

Focusing on emerging markets without commodity exposure is difficult, which is why Source created a new tracking index

When looking at emerging market currencies, Source constructs its own index that reflects currencies not often considered. This list includes Bulgaria, the Czech Republic and Romania – all currencies that are, get this, up on the U.S. dollar during the previous month. Most “mainstream” emerging market currencies are down against the dollar, including Brazil (-6%), Russia (-8%) and the like. It gives China special consideration as a leading importer of commodities.

One interesting use the index provides is that it grants investors the ability to more accurately track emerging markets – many of whom are dependent on commodities. China, for instance, is a net commodity importer and thus is separated to a degree in the analysis:

The obvious way to de-trend currencies is to put them in real terms, using inflation differentials. The results of such a process are shown in Figure 1, with two versions of our real trade weighted EM currency index – one with the Chinese yuan, the other without. The recent divergence is unusual and reflects both the recent strength of CNY and the fact that China now accounts for 37% of the trade weighted basket (in 1990 it was only 12%). In real terms, the peak in EM currencies came in July 2011 (with or without China) and was almost reached again in early 2013.

In other words, as the title of the research piece clearly states: with emerging market currencies “watch commodities, not the Fed.” The Fed "clearly plays a role" in the overall strength of the dollar, but this must be explored further. Versus both emerging market and developed market currencies, those playing close attention to emerging markets should place more weight on the influence of commodities than the Fed. While the two may be linked, the report notes, separating analysis of both can lead to a clearer picture of core performance drivers of strength and weakness.