EM FX Weekly: Goldilocks returns... for now

EM FX Weekly: Goldilocks returns... for now

Forex
John J. Hardy

Chief Macro Strategist

Market conditions for emerging market currencies have improved suddenly over the last week, a whirlwind week that saw China taking a stand on preventing further currency weakness just hours ahead of a non-hawkish Jackson Hole speech from the Federal Reserve’s Powell. Meanwhile, a US-Mexico trade deal that has dreams of trade war détente dancing in the market’s head. Emerging market currencies have generally bounced, though the positive vibe is a patchwork affair, given ongoing individual trouble spots. 

Outlook for EM FX: Investors seeing green from Powell and China

EMs perceived a strong green light from Powell’s Jackson Hole speech from last Friday, in which the Fed chair mulled the Fed’s policy dilemma and the poor quality of traditional indicators for setting the policy rate. Specifically, Powell’s reference to the wisdom of Greenspan’s holding back on further policy tightening in the 1990s and spelling out that the Fed sees no danger for a sudden rise in inflation on the horizon are supportive of the idea that the Fed is going to take it very easy on further policy tightening. The nearly flat yield curve is another indicator suggesting that the Fed won’t hike much more unless the long end of the US yield curve begins to lift in sympathy with Fed policy moves.

Of course, does it not speak volumes about investors’ concerns for long-term growth prospects that the long-term US yield is pinned near and below 3% when GDP growth is pushing 4% and the Trump administration is doing all it can to pump the economy with steroidal levels of stimulus with record deficit levels?

Another decisive and supportive development for EM was China’s timely renewal of the “counter-cyclical factor” in setting the yuan fixing rate, similar to a move back in 2017 that marked the bottom of the CNY at the time. As long as China continues to defend the 6.90-7.00 level in USDCNY, this will provide a modicum of stability, particularly for the Asian exporting economies in China’s orbit.

Finally, the US-Mexico trade deal offers a boost for Mexico, but the peso was already a strong performer and this good news may already be largely priced in. Given uncertainties on policy – especially the risk of fiscal deficits widening – once Obrador takes the helm on December 1, further MXN gains may be harder to come by relative to other EM peers.

From here, we’re a bit tied in knots on the outlook for EM currencies. The markets are pushing a Goldilocks narrative (benign Fed policy despite a strong US economy) that we are uncomfortable with beyond the very short term, though there is a risk that the narrative could hold for another month or even longer, giving EM investors a window of opportunity here for trading gains. In the meantime, the key trouble spots in EM, especially Turkey and Brazil, deserve our attention in coming weeks as Turkey faces a crushing blow to its economy and is still on the path of debt unsustainability, and Brazil faces an election that could cause profound further unrest and economic disruption. 

Chart: USD denominated bonds spreads for selected EMs

The chart below shows the yield spread between US dollar-denominated EM sovereign bonds and US Treasury counterparts with similar maturities. Recent developments have shown some interesting divergences. The most extreme yield spreads are to be found in USD-denominated Turkish sovereign bonds, but the action there has largely tracked the USDTRY exchange rate. Elsewhere, the most extreme divergences are in Russia where the exchange rate is more intensely expressing the fear of further sanctions on Russia than the underlying USD Russian sovereign bonds (hedging activity?).

As well, Brazil’s USD sovereign bonds are not as stressed as the exchange rate ahead of the Brazil election in early October. Indonesia displays perhaps the most divergence in credit spreads solidly improved from their worst levels while the currency continues to weaken versus the US dollar. The focus there may be on its large external debt load (around 35% of GDP according to Bloomberg) while running a 2%-of-GDP current account deficit.

Bond spreads
Source: Bloomberg, Saxo Bank
Chart: Global Risk Index... slipping into positive territory?

Risk conditions have improved and are nearly back to neutral in our Global Risk Indicator and could slip into positive territory in coming days. Note, however, the number of times this occurred back in 2015 before EM assets posted their major low in early 2016. Among the indicator’s subcomponents, corporate credit measures have improved the most, while volatility indicators have been benign (still interesting that US indices showing considerable divergence and the VIX is not near the cycle lows even as the overall average has blasted to an all time high this week) and EM credit spread improvement has been rather modest at best.

It all feels rather fragile, but we could be in for a tradeable bout of improvement in risk appetite across markets that could support EM assets, though we are unsure at this point whether the recent stress event marks a major low for EM broadly for now. 
Global risk
Source: Bloomberg, Saxo Bank
EM currency performance: Recent and longer term, carry-adjusted

Chart: the weekly spot and one-month carry-adjusted EM FX returns versus USD:
 The short-term performance chart below reminds us of how extreme the recent devaluation in the Turkish lira has been, and the Russian ruble and Brazilian real have been other trouble spots over the last month. Still, most EM currencies in our universe managed a flat to positive performance for the last week, with the Chinese yuan and the surplus countries in China’s orbit managing a positive performance over the last month as well.
EM FX performance
Source: Bloomberg, Saxo Bank
Chart: Three- and 12-month carry-adjusted EM FX returns versus USD: The latest trouble spot for EM kicked into high gear around the beginning of May, and China moved away from its strong CNY policy about two months ago, so no surprise that the three-month performance is still negative for nearly every currency save for the Mexican peso, which marches to a different beat.
EM FX performance
Source: Bloomberg, Saxo Bank

Quarterly Outlook

01 /

  • Macro Outlook: The US rate cut cycle has begun

    Quarterly Outlook

    Macro Outlook: The US rate cut cycle has begun

    Peter Garnry

    Chief Investment Strategist

    The Fed started the US rate cut cycle in Q3 and in this macro outlook we will explore how the rate c...
  • Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Quarterly Outlook

    Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges

    Althea Spinozzi

    Head of Fixed Income Strategy

  • Equity Outlook: Will lower rates lift all boats in equities?

    Quarterly Outlook

    Equity Outlook: Will lower rates lift all boats in equities?

    Peter Garnry

    Chief Investment Strategist

    After a period of historically high equity index concentration driven by the 'Magnificent Seven' sto...
  • FX Outlook: USD in limbo amid political and policy jitters

    Quarterly Outlook

    FX Outlook: USD in limbo amid political and policy jitters

    Charu Chanana

    Chief Investment Strategist

    As we enter the final quarter of 2024, currency markets are set for heightened turbulence due to US ...
  • Commodity Outlook: Gold and silver continue to shine bright

    Quarterly Outlook

    Commodity Outlook: Gold and silver continue to shine bright

    Ole Hansen

    Head of Commodity Strategy

  • FX: Risk-on currencies to surge against havens

    Quarterly Outlook

    FX: Risk-on currencies to surge against havens

    Charu Chanana

    Chief Investment Strategist

    Explore the outlook for USD, AUD, NZD, and EM carry trades as risk-on currencies are set to outperfo...
  • Equities: Are we blowing bubbles again

    Quarterly Outlook

    Equities: Are we blowing bubbles again

    Peter Garnry

    Chief Investment Strategist

    Explore key trends and opportunities in European equities and electrification theme as market dynami...
  • Macro: Sandcastle economics

    Quarterly Outlook

    Macro: Sandcastle economics

    Peter Garnry

    Chief Investment Strategist

    Explore the "two-lane economy," European equities, energy commodities, and the impact of US fiscal p...
  • Bonds: What to do until inflation stabilises

    Quarterly Outlook

    Bonds: What to do until inflation stabilises

    Althea Spinozzi

    Head of Fixed Income Strategy

    Discover strategies for managing bonds as US and European yields remain rangebound due to uncertain ...
  • Commodities: Energy and grains in focus as metals pause

    Quarterly Outlook

    Commodities: Energy and grains in focus as metals pause

    Ole Hansen

    Head of Commodity Strategy

    Energy and grains to shine as metals pause. Discover key trends and market drivers for commodities i...
Disclaimer

Saxo Capital Markets (Australia) Limited prepares and distributes information/research produced within the Saxo Bank Group for informational purposes only. In addition to the disclaimer below, if any general advice is provided, such advice does not take into account your individual objectives, financial situation or needs. You should consider the appropriateness of trading any financial instrument as trading can result in losses that exceed your initial investment. Please refer to our Analysis Disclaimer, and our Financial Services Guide and Product Disclosure Statement. All legal documentation and disclaimers can be found at https://www.home.saxo/en-au/legal/.

The Saxo Bank Group entities each provide execution-only service. Access and use of Saxo News & Research and any Saxo Bank Group website are subject to (i) the Terms of Use; (ii) the full Disclaimer; and (iii) the Risk Warning in addition (where relevant) to the terms governing the use of the website of a member of the Saxo Bank Group.

Saxo News & Research is provided for informational purposes, does not contain (and should not be construed as containing) financial, investment, tax or trading advice or advice of any sort offered, recommended or endorsed by Saxo Bank Group and should not be construed as a record of our trading prices, or as an offer, incentive or solicitation for the subscription, sale or purchase in any financial instrument. No representation or warranty is given as to the accuracy or completeness of this information. All trading or investments you make must be pursuant to your own unprompted and informed self-directed decision. No Saxo Bank Group entity shall be liable for any losses that you may sustain as a result of any investment decision made in reliance on information on Saxo News & Research.

To the extent that any content is construed as investment research, such content was not intended to and has not been prepared in accordance with legal requirements designed to promote the independence of investment research and as such, would be considered as a marketing communication.

None of the information contained here constitutes an offer to purchase or sell a financial instrument, or to make any investments.Saxo Capital Markets does not take into account your personal investment objectives or financial situation and makes no representation and assumes no liability as to the accuracy or completeness of the information nor for any loss arising from any investment made in reliance of this presentation. Any opinions made are subject to change and may be personal to the author. These may not necessarily reflect the opinion of Saxo Capital Markets or its affiliates.

Please read our disclaimers:
- Full Disclaimer (https://www.home.saxo/en-au/legal/disclaimer/saxo-disclaimer)
- Analysis Disclaimer (https://www.home.saxo/en-au/legal/analysis-disclaimer/saxo-analysis-disclaimer)
- Notification on Non-Independent Investment Research (https://www.home.saxo/legal/niird/notification)

Saxo Capital Markets (Australia) Limited
Suite 1, Level 14, 9 Castlereagh St
Sydney NSW 2000
Australia

Contact Saxo

Select region

Australia
Australia

The Saxo trading platform has received numerous awards and recognition. For details of these awards and information on awards visit www.home.saxo/en-au/about-us/awards

Saxo Capital Markets (Australia) Limited ABN 32 110 128 286 AFSL 280372 (‘Saxo’ or ‘Saxo Capital Markets’) is a wholly owned subsidiary of Saxo Bank A/S, headquartered in Denmark. Please refer to our General Business Terms, Financial Services Guide, Product Disclosure Statement and Target Market Determination to consider whether acquiring or continuing to hold financial products is suitable for you, prior to opening an account and investing in a financial product.

Trading in financial instruments carries various risks, and is not suitable for all investors. Please seek expert advice, and always ensure that you fully understand these risks before trading. Saxo Capital Markets does not provide ‘personal’ financial product advice, any information available on this website is ‘general’ in nature and for informational purposes only. Saxo Capital Markets does not take into account an individual’s needs, objectives or financial situation. The Target Market Determination should assist you in determining whether any of the products or services we offer are likely to be consistent with your objectives, financial situation and needs.

Apple, iPad and iPhone are trademarks of Apple Inc., registered in the US and other countries. AppStore is a service mark of Apple Inc.

The information or the products and services referred to on this website may be accessed worldwide, however is only intended for distribution to and use by recipients located in countries where such use does not constitute a violation of applicable legislation or regulations. Products and Services offered on this website is not intended for residents of the United States and Japan.

Please click here to view our full disclaimer.