Having more than reversed a pandemic-induced slump and hit a record high last month, the wider index of emerging market currencies fell to over a one-month low after the Fed projected an acceleration to its policy tightening timeline.
Wary that U.S. stimulus could be tapered sooner, in coming months investors may shun the currencies coined the "fragile five" of Brazil, India, Indonesia, Turkey and South Africa, as they did in 2013 when the Fed tightened rates.
Although fundamentals, valuations and positioning are different than in 2013, nearly 60% of 57 FX strategists in a June 28-July 1 Reuters poll said emerging market currencies were at high risk from possible tapering by the Fed this year.
"As markets fine tune expectations around the Fed's asset purchase reduction and hike trajectory, USD may remain on a stronger footing," said Johanna Chua, EM Asia economist at Citi.
"Volatility around inflation expectations - and relatedly in commodities, equities etc. - may cause volatility in EM currencies alongside too, but broadly investors may remain cautious of taking bullish EM FX exposure." Chua added.
(Reuters poll graphic on emerging market currencies outlook: https://fingfx.thomsonreuters.com/gfx/polling/yzdpxlxqmpx/EM%20FX%20July%202021.PNG)
The survey showed a mixed outlook for emerging market currencies, as Brazil's real, India's rupee and Turkey's lira were forecast to weaken while China's yuan, Russia's rouble and South Africa's rand were expected to gain in the next 12 months.
When asked which EM currencies would perform better this year if the U.S. yield curve steepens, 15 of 42 respondents said commodity currencies in general, 11 said reflationary hikers, 11 said high yielding and five said low yielding.
"Expect those currencies backed by large commodity exports or with central banks taking a conventional approach to normalization to outperform," said Chris Turner, global head of markets at ING.
"Asia is the weak link currently. Renewed lockdowns and their impact on supply chains and global demand need to be monitored carefully. Yet on balance we expect the Renminbi to stay in demand - after all it is a high yielder."
The most actively-traded emerging market currency, the Chinese yuan, was predicted to edge up about 1% to 6.4 per dollar in a year.
South Africa's rand, another high-yielder but among the worst performing emerging market currencies in June, is set to gain over 2% to 14.0/$ in the next six months.
"South Africa's narrative has improved considerably in the past several months and we believe the rand will see further gains in the near future," said Phoenix Kalen, head of emerging markets research at Societe Generale.
"The rand will continue to benefit from the global economic recovery, elevated metals and mineral commodity prices, and favourable market risk sentiment."
Oil currencies such as Russia's rouble fell to more than a one-week low on Wednesday as the peak of a favourable domestic tax period passed and concerns over surging COVID-19 cases at home and abroad tampered risk appetite.
But the rouble was expected to gain about 2% to 71.5/$ in a year.
"Lockdowns, rising inflation, politics and low oil prices were headwinds for the rouble in 2020 but these factors have turned supportive for stronger RUB," said Lars Sparresø Merklin, senior FX analyst at Danske Bank.
"As the recovery is ongoing, the central bank is hawkish and political risks are fading, rouble may see further support from here."
While high oil prices benefit exporters such as Russia and much of Latin America, importers like India and Turkey suffer.
The Indian rupee, which posted its biggest monthly drop in June since the onset of the pandemic in March last year, is set to depreciate another 0.5% to 74.75/$ in a year.
The Turkish lira is set to fall over 9% to 9.5/$ in the next 12 months.
(Reporting by Vivek Mishra and Vuyani Ndaba; Polling by Md. Manzer Hussain and Shaloo Shrivastava, Editing by William Maclean)
By Vivek Mishra and Vuyani Ndaba