A strong dollar story: Peso plays “depreciation catch-up”

The US Federal Reserve has been hiking its Fed Funds rate aggressively in the past few meetings, with the latest at 75 basis points (bps) and with further signals of another 50- to 75-bp hike this July, and more to come afterwards. The result is a renewed interest in US financial assets, which also generally translates to a strong dollar as investors buy dollars and sell whatever currencies they may have.

For the Philippines, this means a depreciating peso. As the chart below shows, the peso generally depreciates when the Fed Funds rate go up, and it appreciates when the Fed Funds rate comes down, at least trend-wise.

For example, in the period following the Great Recession of 2008, the effective Fed Funds rate came all the way down to near zero and, as a result, the peso generally appreciated all the way to 2013. On the other hand, between 2015 and 2019, the peso depreciated as the Fed Funds rate went up.

Market expectations drive the movement of the peso exchange rate.

However, there was a curious situation highlighted in the chart in 2013. It shows the peso actually depreciating way before the Fed actually started hiking rates in 2015. So, what gives? It turns out that the Fed started talking about tightening monetary policy in 2013 and, as a result, the peso depreciated.

So, it’s not just actual rate cuts or hikes that move the peso, but also market expectations of rate cuts or hikes. Therefore, market expectations of what the Fed will do is as important as what the Fed actually does, and these expectations actually move the exchange rate directly. The same was true in 2021, as market expectations of Fed hikes started to push up the peso and make it depreciate, even though the Fed actually started raising rates only this 2022.

It also appears that with the expected aggressive rate hikes, the markets are pricing in an even weaker peso, with the peso hitting the 55 level already, up from 51 at the start of 2022. However, currently, there is a bit of market noise on just how far up the peso is expected to weaken. In light of recent movements in other currencies, it might appear that the peso is weakening too much when looking at the recent past. However, when taking a look at a longer window, it can also appear that the peso in fact is just playing catch-up with the rest of the pack.

In this chart below, movements of the ASEAN currencies plus the yen are converted to an index based on January 2018. The overall changes relative to the base are then tracked for comparison. The 2018 base was chosen given that then, as now, there was high inflation for the Philippines.

It turns out that when tracked this way, the peso is not the currency that depreciated the most. Our ASEAN peers plus Japan have currencies that depreciated even more than the peso relative to 2018 prices.

The peso did not perform as badly as other ASEAN currencies as many may think. With high economic growth and strong imports, the peso is now playing “depreciation catch-up”.

It is perhaps not that relevant to ask whether the peso is leading the pack or is behind the pack in terms of depreciation given the different ways the observation window can be framed. Perhaps the real question should be, why did the peso appreciate too much in 2020 to 2021 relative to the pack?

That answer is simple; it’s because the country did not import that much during that period due to demand destruction and the lockdowns. However, OFW remittances and BPO revenues continued to come in and dominate the balance of payments, leading to peso strength. Our peers, on the other hand, are export- oriented, heavily dependent on the trade of goods (or tourism, in the case of Thailand) which, of course, collapsed due to the pandemic lockdowns. As a result, their currencies didn’t appreciate as much as the peso.

And because of that, the “base effect” is much more significant for the Philippines as the Fed started signaling rate hikes in 2021, completely reversing the trend. The peso is playing “depreciation catch-up” (with heightened base effects) with its peers as high economic growth, and thus, strong imports, are back in play.

Ah, yes, economic growth! With continuing growth, there will be more imports at higher inflated global prices, and the 3rd quarter is traditionally when imports are strongest. It should be expected that the peso will continue to weaken at this point.

When imports ebb by the 4th quarter and OFW remittances start to dominate once again going into the Christmas season, and with BPOs continuing to become even more competitive given the weaker peso, the peso should start getting appreciation pressure towards yearend. All the while, the Fed rate hikes will continue way into 2023. In the end, the call is still a weaker peso. After all, it’s still a strong dollar story.

MARC BAUTISTA, CFA, is Vice-President and Head of Research & Business Analytics at Metrobank, in charge of the Bank’s macroeconomic, industry, and financial market analysis and research. He loves teaching finance and investments, portfolio management, statistics, financial derivatives, economics, etc. in a university setting. He plays guitar in a rock band and loves learning other languages, especially Spanish, promoting its recovery as a heritage language in the Philippines.