EM FX Weekly: Goldilocks returns... for now
Head of FX Strategy
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.
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.
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.
Latest Market Insights
Outrageous Predictions 2023: The War Economy
- The constantly growing global need for energy drives the world's richest to huddle up and launch a R&D project in a size the world hasn't seen since the Manhattan Project gave the US the first atomic bomb.
French President Macron resignsThe political stalemate in France and the rise of Marie Le Pen following the 2022 elections corners President Macron, forcing him to give up on politics and resign from his position. At least for now.
Gold rockets to USD 3,000 as central banks fail on inflation mandateAs markets and central banks realise that the idea that inflation is transitory is wrong, and that prices will remain higher for longer, gold is sent through the roof, hitting a price tag of USD 3,000
EU Army forces EU down path to full unionWith continued challenges in the region and a US military that isn't aggressively enacting its former role as global policeman, the European Union agrees to create its own armed forces, bringing the whole region closer.
A country agrees to ban all meat production by 2030In an effort to become one of the global leaders on the path to net-zero emissions, one country decides to not only put a heavy tax on meat, but to ban domestic production entirely.
UK holds UnBrexit referendumFollowing a recession and domestic pressure, the United Kingdom is thrown into political turmoil that will end with a vote to wind back Brexit.
Widespread price controls are introduced to cap official inflationHistory tells us that with the war economy comes rationing and price controls. And this time is no different, as policymakers introduce strict price controls that lead to a range of unintended consequences.
OPEC+ & Chindia walk out of the IMF, agree to trade with new reserve assetSanctions against Russia have caused widespread turmoil due to US Dollar moves in countries across the globe that don't consider the US an ally. To relieve themselves from this, they leave the IMF and create a new reserve asset.
USDJPY fixed to the USD at 200 as Japan overhauls financial systemFollowing the challenges that faced the Japanese Yen in 2022, the Bank of Japan attempts to keep the currency from sliding. Unsuccessful on the long-term, Japan will launch a reset of its entire financial system.
Tax haven ban kills private equityWith the war economy comes an increased focus on national interests and sovereign nations' ability to assert themselves. In that regard, the OECD countries turn their attention on tax havens and pull the big guns out, banning them altogether.