The rally is being driven by two principal factors. First, investors came to the gradual realization that the trend towards risk aversion had reached extreme proportions. Given that the crisis in the EU has been fairly limited both in scope and extent (at least so far), it made little sense to punish emerging markets. If anything, emerging markets should have been the financial safe havens: “Debt-to-GDP ratios in the developed world are about double those in emerging markets, and they’re growing. This makes emerging markets interesting because you’re picking up incremental spread and in return you’re actually taking less macroeconomic risk.”

Other analysts see a certain futility in targeting a risk-averse strategy: “It’s not that people suddenly think emerging markets are a lot safer, it’s that they’re realising risk is everywhere and they can’t just assume the developed world is safe.” In other words, some investors are wondering whether it doesn’t make sense to focus less on risk – which  has become increasingly random – and more on return. In this aspect, emerging market investments of all kinds are more attractive than their counterparts in the developed world.

The second source of momentum for the rally is a long-term shift in capital allocation. Thanks to foreign demand, Emerging Market “borrowers, including governments and companies, have raised almost $300bn (£200bn) to date, up 10 per cent on the same period in 2009.” A microcosm of this surge can be seen in US mutual funds: “Emerging market equity funds…posted combined inflows of more than $3 billion for the week ended July 14, while emerging market bond funds took in $745 million, bringing their year-to-date inflows to an all-time high of $18.5 billion.”

Across all sectors, money is pouring into emerging markets at an even faster pace than before the credit crisis. This time around, however, analysts argue that it is justified by fundamentals: “Economies in the developing world are slated to grow 6.3% this year and are expected to maintain a similar growth rate through 2013, according to the International Monetary Fund. Advanced economies are seen expanding around 2.4% annually over the same time period.” The Brazilian economy alone expanded at an annualized rate of 9% in 2010 Q1, the fastest rate in 15 years!

Emerging market investors share the confidence of foreign investors, and it seems the flow of funds will primarily be one-way. According to a recent survey, “Just 19 per cent of Brazilians, 15 per cent of Indians and 11 per cent of Chinese…said they anticipated increasing cross-border investment.”

At this point, the only thing that could derail emerging markets is if investors get too ahead of themselves. According to Citigroup, “Developing-nation shares will rally 20 percent to 25 percent by the end of this year as the world economy avoids a double-dip recession and attractive valuations lure investors.” That would bring share prices past the current level and dangerously close to the pre-credit crisis highs of 2008. The JP Morgan Emerging Market Bond Index (EMBI+) has already shattered its previous record, and given the current spread of only 300 basis points to US Treasuries (which themselves are trading near all-time lows), one has to wonder if investors aren’t at risk of re-entering bubble territory.

If for whatever reason investors get spooked, it could spark the same capital flight that followed the bankruptcy of Lehman Brothers, in which emerging market and commodity currencies alike fell 30-50% over a duration of mere months. While no one is predicting a similar outcome this time around, I think prudence and caution are nonetheless advisable.

Initial jobless claims rose from 427k…

Over the last month, the Chinese RMB has appreciated by slightly less than 1% against the Dollar, although most of that jump took place in the day that followed the June 19 announcement. After the initial excitement faded, a sense of disappointment set in as it became clear that China had no intention of allowing the RMB to appreciate rapidly: “The subsequent appreciation of the yuan against the dollar is likely to be small, perhaps just a few percent over the remainder of the year.” In fact, futures prices reflect only an additional 1.5% appreciation over the next 12 months.

 Due both to its slow speed and small scope, the revaluation could conceivably benefit the Chinese economy. That’s because in the short-term, a more expensive currency will mean higher prices paid for exports. The quantity of exports is unlikely to decline, such that total export revenues could actually increase. According to one analyst, “With Chinese imports, there are no substitutes in the short term. Maybe in 10 years, importers will have a choice, but right now they will just have to pay more. No other country…can build a manufacturing base and all the infrastructure that you need — transportation, energy, the entire value chain to the final good — takes many years.” As if on cue, China’s trade surplus expanded in June, in spite of the revaluation of the Yuan.

As a result, American manufacturers and other vested interests have announced that they will continue to lobbythe US government to pressure China on the currency issue, on the basis that the undervalued RMB is eroding both the US economy and the labor market. Argued the director of the Peterson Institute for International Economics, “The case for a substantial increase in the value of the renminbi is thus clear and overwhelming. An appreciation of 25% to 40% is needed to cut China’s global [account] surplus even to 3% to 4% of its GDP. This realignment would produce a reduction of $100 billion to $150 billion in the annual U.S. current account deficit.” It might also help to restore the estimated 1.4 million jobsthat have been lost due to China’s forex policy. According to analysts, however, political infighting make it unlikely that any new law or punitive tariffs will be imposed anytime soon.

At the very least, China will continue to make the Yuan more flexible, so that one day it can float freely. It has already moved to facilitate trade settlement in Yuan, and analysts expect ” ‘more than halfof China’s total trade flows, primarily bilateral trade with emerging markets, to be settled in renminbi in the next three to five years.’ ” China is also making it more attractive for foreign investors to hold Yuan, by loosening controls that govern Chinese capital markets and creating new investment vehicles that will cater directly to foreigners. In the mean time, holding RMB is pretty unattractive given both “the hassle of getting money in and out of China” and the low rates offered by Chinese money market funds.

As for the impact on the rest of the forex market, I think that commodity currencies and growth currencies could come out ahead. The move signals an implicit confidence in the global economic recovery and can perhaps be seen as a harbinger for high commodity prices: In addition, it will “provide a boostto U.S. exports, employment, earnings and growth, reinforcing the case for growth sustainability at a time when investors are more fearful than they were in April.” The US Dollar, on the other hand, could emerge as one of the big losers. Already, China’s forex reserve growth has slowed to the weakest pace in 11 years. This trend will probably continue, since smaller purchases of Dollars will be required to maintain the floating peg. In fact, the Euro’s recovery against the Dollar has coincided mysteriously with the revaluation of the Yuan. While this is probably just a coincidence, it is nonetheless symptomatic of a declining role for the Dollar as the world’s reserve currency. But that is a topic for another day…