LONDON May 24 As the dust settles on a volatile week, many strategists now sense a green light for a long-brewing multi-year rise of the U.S. dollar - with unnerving portents for emerging markets.
The U.S. Federal Reserve's now open debate about the beginning of the end of its massive money-printing programmes caused gyrations on stock and bond markets everywhere this week.
Even the prospect of the Fed reducing the amount of dollars it's been flooding into the domestic and global economies via its bond-buying policy has seen several strategists crank up long-term dollar forecasts significantly.
The scenario raises concerns among many economists of what's become known as "sudden stops" in western investment flows to emerging markets - the most spectacular being the 1997/98 currency crises across Asia, Russia and Latin America but yet again at the height of the credit crisis in late 2008/2009.
And that 1990's crash coincided with a sustained dollar rally over many years and an investor shift back to the United States.
The bullish case for the dollar has been building for months - U.S. growth rates outstripping western peers; an entrenched housing recovery; cheaper domestic energy from shale and its likely shrinkage of U.S. trade deficits; and even the relocation of some U.S. industry back home have been oft-cited factors.
But these tailwinds have struggled to lift the dollar to date as long as the Fed's dollar printing weighed down its exchange rates. If that headwind were now even to weaken from storm force to a mere gale, then lift-off may be in sight.
"We cannot think of a better environment for further dollar over-peformance, irrespective of gyrations in U.S. equities," said Citi emerging markets strategist Luis Costa, scaling back overweight recommendations on some emerging debt in the process.
HSBC strategist David Bloom, ratcheting up the bank's end-year dollar forecasts, reckons low global inflation is allowing central banks everywhere to step up the "currency war" and weaken local units via lower interest rates or outright currency sales in an anxious dash to offset flagging growth.
Armed with a pick up in its domestic economy, the dollar could now absorb that worldwide push to devalue.
"We believe we have entered a dollar bull environment," he said, adding that any Fed shift in the opposite direction would simply reinforce significant dollar appreciation of 10 percent or more before U.S. authorities would feel any need to object.
BOON OR BOMB?
So if a higher dollar trajectory is now in view, why all the nerves about emerging markets? Taking comfort from exporters' relief at weakening currencies, for example, Turkish and South African equities barrelled to record highs this week.
The broader anxiety is that a decade of staggering investment flows to emerging economies - some $8 trillion since 2004 on some estimates - has ridden on the back of both a commodities "super cycle" over the past decade and a protracted strengthening of emerging currencies against the dollar.
The Fed's inflation-adjusted and trade-weighted dollar index against a broad sweep of mostly developing countries, for example, has fallen more than 25 percent over the past 10 years.
But if both the long-term commodity price surge and a weakening dollar are at a long-term turning point, then the metrics of investment in emerging markets may shift also - with nearly half of the $80 trillion of world's private pension, insurance and mutual funds still based in the United States.
What's more, the latest investor wave into emerging markets has been into bond markets - much of it denominated in local currencies and where index-wide yields are near record lows.
JPMorgan estimates total new sovereign and corporate bond sales from emerging markets soared to a record of $411 billion last year alone, some 30 percent higher than 2011.
The combination of local currency losses against the dollar and higher U.S. bond yields over the coming years could seriously disturb those investment calculations, not least in a period where economic growth rates in China and other developing giants are slowing relative to the United States.
In a note to clients on Thursday entitled "Emerging markets on tenterhooks", Barclays said: "The interplay of supportive emerging market (debt) fundamentals and uncertainty about U.S. Treasury yields leaves EM fixed income on an uncertain footing."
Developing economies and markets are more robust now, argue optimists. There are fewer fixed currency pegs and more flexible exchange rate adjustments which reduce the chance of sudden shocks. Foreign cash reserves are far higher after 10 years of inflows and government debt positions and credit quality have improved and are, in some cases, even superior to the West.
Societe Generale says many investors have added emerging bonds to portfolios of late because they have become both less volatile and less correlated with other assets - hence they are holding them to stabilise portfolios.
Goldman Sachs insist that painting emerging markets with one brush is misleading and the dispersion of returns within the emerging market universe is rising. Picking the right ones - Turkey or Indonesia equities so far this year - is the best strategy, they say.
But with many investors still invested in broad emerging markets buckets or indices, the combined dollar and U.S. yield reversal along with slower emerging world growth could still be dangerous for both the stars as well as the laggards.
And for risk-wary fund managers there are liquidity concern about - the ease of selling at a fair price during a crash.