Head of FX Strategy
Conditions for EM currencies have worsened further as global bond yields have rebounded after the Italian election-inspired disruption and as EM credit spreads have shown further signs of strain. The odd indicator out remains suppressed market volatility, as low volatility and strong risk appetite in developed markets rarely coincides with EM currency distress. This week’s FOMC meeting could throw a lifeline to emerging markets if the Fed slows its quantitative tightening schedule and/or loosens its commitment to the current pace of rate hikes. But this is far from a sure thing, as the Fed may be looking for more flexibility rather than trying to make the explicit dovish shift that would provide some more profound near-term relief for EMs.
EM developments over the last week
A few specific EM currency developments for the EN currencies with the widest performance swings this week:.
TRY: the Turkish lira managed a resilient performance last week after the Turkish central bank hiked the repo rate 125 basis points in a move that few anticipated. The extreme TRY carry helps to offset the strain on Turkey’s credit spread, which has worsened back toward the worst levels for the cycle even as the lira exchange rate has at least attempted a recovery. The currency weakness should begin to right the current account situation in the months ahead as well. The next critical steps for Turkey lie on the other side of the June 24 presidential election and how President Erdogan responds to the flogging the country’s exchange rate has been administered by global markets. Has he been cowed or could he reach for desperate measures? The potential is there for a full blown crisis and even default if conditions for EM worsen further and Turkey’s leadership makes the “wrong” decisions.
BRL: The Brazilian real saw a roller coaster ride over the last couple of weeks, first lurching into an ugly slide even after a paralysing strike concluded as a rising popular chorus supports military intervention and the right-wing populist Bolsonaro gained political momentum from the episode. Last Friday, however, the Brazilian central bank made a more pointed promise to deliver enough intervention to stem the flow out of the currency, and the BRL rallied to recover all of the losses over the prior week. The actual spread on Brazilian USD-denominated debt versus a US treasury counterpart has not improved, however, as we point out below, so the sustainability of the real’s comeback is still an open question as the country faces a long wait until October elections and the new angle of (also an echo of Brazil’s past) right-wing populism and the military in the mix.
Chart: We highlight a quartet of the EM currencies below for which credit spreads on USD denominated debt has worsened again recently to, or close to, cycle wides. Without improvement in the appetite for EM assets, the currencies will remain under pressure and the recent volatility may have also seen hedging demand for existing portfolio exposures picking up. All four of the countries charted below have sufficiently large external debt loads that point to the risk of the situation getting worse if authorities can’t improve foreign investor confidence. Note the remarkable situation in South Africa as well, where the specific USD bond yield spread is almost back to where it was when the currency was under the most pressure during the final portion of former President Zuma’s rule late last year.
MXN. Since our last update on the first of the month, MXN has come under further significant pressure not only from general strains on EM, but also as Mexico took the step of announcing its own tariffs on US pork and other products, a move guaranteed to elicit a pointed response from the Trump administration – though things could go quiet on the trade front until after the left populist Obrador (assuming overwhelming polling leads are correct) assumes office and makes his bargaining position clear. There is a strong domestic focus in Orbrador’s platform that has the market concerned for the fiscal and current account implications. We are in the countdown phase to the July 1 election at which populist Obrador is widely expected to gain a strong mandate.
IDR: formerly a “fragile five” member (together with India, Turkey, Brazil and South Africa), Indonesia has unleashed the most aggressive official response to the general malaise impacting emerging markets. The central bank faces an easier task than elsewhere in defending the currency as the country’s external debt load is somewhat lower than many of the more fragile EM peers at around 33% of GDP, the country has a large export exposure to China and that country’s strong currency. The central bank and its new governor Warjiyo have countered recent currency weakness with policy tightening and stout promises to do more if necessary to stay ahead of the problem.
Chart: Global Risk Index – odd combination of risk off with pockets of complacency
The Global Risk indicator remains in risk off territory, with a very different twist from the episode that inaugurated the long run in risk averse territory back in early February. Back then, sudden violent market volatility was the focus, with few signs of strain in credit spreads and other indicators. This time around, the situation is the reverse, though spreads in both credit and EM credit are still quite far from where they were when the brutal USD strengthening rode roughshod over EM back in late 2014 and for most of 2015 as well.
EM Currency Outlook: The FOMC could bail out EM for the short to medium term, but will it?
The current hopes for an EM recovery rest in US Federal Reserve’s hands and this Wednesday’s FOMC meeting is the marquee event for a change of pace that could provide EM at least a window of relief for some time. The argument goes that the Fed could shift the current quantitative tightening schedule due to the blizzard of treasury issuance. The Fed could do so without losing too much credibility as the Trump tax reform was passed well after the Fed could ever have anticipated. As well, Fed Chairman Powell has indicated a preference for policy flexibility, especially now that the Fed funds rate will soon reach a longer-term neutral rate from its long stay in the accommodative zone. Leaving the QT on some sort of automatic tightening clock makes little sense in that regard, especially as the QT schedule is set to reach a pace of shrinking the Fed’s balance sheet by some $40 billion a month as of July 1 or nearly half of the pace of the Fed’s enormous QE3 purchases back in the late 2012 to 2013 period.
It’s possible, then, that the Federal Open Market Committee gives the EM a reprieve for the coming few weeks or even a quarter, but ultimately this move may be seen as the Fed looking for more flexibility rather than waxing dovish and late cycle concerns still have us looking for further strain on EM and deeper discounts before expressing interest in exposure to EM currencies. At the same time, a number of Fed members have expressed concern that the flattening and now nearly flat US yield curve represents a hurdle for raising short-term interest rates much further, so how the Fed deals with further policy rate adjustments when the term premium is vanishing is another open question. At least one prominent Fed member, Lael Brainard on the Fed’s Board of Governors, however, seems unperturbed by the prospects of the yield curve flattening and perhaps even inverting. Regardless, if this or coming FOMC meetings and a guidance shift from the Fed fail to cap US yields, EM assets and currencies may not even receive a near-term reprieve.
EM currency performance: Recent and longer term, carry adjusted
Chart: the weekly spot and 1-month carry-adjusted EM FX returns vs. USD. Individual short-term performance metrics are misleading over the last week for the Brazilian real, which saw a collapse and then even larger recovery in the space of a week – while it is still down for the month. The worst performer over the last week and month has been the South African rand, where credit spreads have worsened after an ugly GDP decline in Q1 was reported last week.
Chart: 3-month and 12-month carry-adjusted EM FX returns vs. USD
The four weakest links over the last four months – TRY, BRL, ZAR and MXN are our focus in the credit spread chart. In Asia, China continues to provide an anchor for most other Asian currencies with its very low beta moves to the general USD direction and declared strong CNY policy.
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