EM FX Weekly: USD, US yields pause... but can EM revive?
Head of FX Strategy
EM currencies saw a roller coaster week, especially the Turkish lira, which suffered a near-freefall until the central bank was finally forced to act to shore up confidence in the lira, with the jury still out on whether the political leadership will continue to sabotage the currency’s prospects.
Questions remain on EM currencies’ revival prospects; global risk developments haven’t improved, even as the immediate pressures from a stronger US dollar and higher US yields have eased in the wake of the release of the most recent Federal Open Market Committee minutes.
EM news and views
A rocky ride for EM currencies this week, as the USD rally was largely sidelined and US yields fell after posting new highs for the cycle last week around the time we published our prior edition of this publication. The US 10-year benchmark’s recent break to new highs since 2011 has so far failed to trigger any notable meltdown in US Treasuries, and recently lower US rates have thrown a bit of a lifeline to EM currencies, many of which have bounced back from last week’s lows.
The FOMC minutes published Wednesday provided an interesting catalyst for US bond yields this week. Those minutes deepened the impression that the Fed is willing to allow inflation to run a bit hotter without triggering a further upgrade to the anticipated rate hike path. As well, the Fed is beginning to fret how it will downshift its guidance as the policy rate gets closer to acting as a brake on the recovery. The fate of the US 10-year yield around 3.00% and the forward guidance at the next FOMC meeting on June 13 are looking like two key factors affecting global risk appetite and therefore conditions for emerging market currencies from here.
Still, as we underline in our coverage of global risk appetite below, the USD and US yield situation aren’t the only drivers of risk appetite, and there has been no improvement of late in the risk backdrop.
One distinct pattern that has manifested over the last several weeks is the relative strength of some of the most commodity-linked currencies in both DM and EM, from AUD and CAD in DM to RUB, BRL, CLP, ZAR and COP among EM’s. The market seems to be taking a position on the potential for commodity inflation from here.
A rundown of specific EM currency developments:
RUB: the ruble has provided a bastion of stability in a relative volatile environment. Even as geopolitical issues rage on, we haven’t seen new conclusive evidence on how the US’ renewal of sanctions against Iran will affect global oil supplies, and Russia’s leadership has taken a bit of low profile stance on all geopolitical fronts recently. Brent crude oil touching near $80/barrel is a major support for the ruble and the Russian central bank leadership has communicated that it is interested in upgrading the priority of exchange rate stability relative to more accommodative monetary policy after the new US sanctions levied earlier this year pushed the ruble sharply lower.
TRY: the Turkish lira dominated the EM news cycle over the last week, as the virtual freefall in TRY continued and accelerated this week until finally the central bank stepped in with a 300 basis point hike to the key rate and soothing language, including from the chief source of the lira’s woes: President Erdogan, who claims that Turkey would abide the principles of global markets. Uncertainties remain, especially linked to the risks of Erdogan’s response once he has assumed the expanded powers of the new presidency on the other side of the June 24 election, still uncomfortably far away. The very day after the central bank’s emergency hike, Erdogan’s party was out circulating the party’s election platform, which touted the need to maintain single digit inflation and to reduce the burden from high interest rates. Ouch. Significant damage has already been done to the Turkish economy by this latest episode, though one salutary – or at least balancing – effect of this recent episode should be a reduced current account deficit.
CNY: no change of strategy from China, as CNY has weakened with very low beta to the strong US dollar. It it clear that CNY stability exerts a strong gravitational pull on regional currencies, as even the back and forth on whether a North Korea/US summit will take place after all has hardly raised eyebrows in the USDKRW exchange rate over the last week.
Chart: EM commodity exporters the outperformers
The chart below shows the carry-adjusted returns for a long basket of commodity exporters RUB, BRL, COP, and CLP versus a short basket of next commodity importers and current account deficit countries INR, PHP, MXN, and TRY. Just as commodity prices have risen from the lows of early 2016, the return of commodity-exporting emerging market currencies have also outperformed relative to commodity importers/current account deficit EM’s.
The fundamental case makes sense, of course, but we have long range concerns on the strength of global growth, normally something that is negative for commodity prices. If we are to see weaker growth but higher commodity prices, it would be an environment not witnessed since the 1970’s and would suggest some new highly inflationary monetary regime. Stay tuned.
MYR: the ringgit has remained stable and difficult to differentiate with the performance of the CNY over the last week, despite the unfolding political revolution and the risk to the fiscal balance from some of the measures proposed by the newly elected (92-year-old former) president Mahathir.
Chart: USDMYR versus USD
The chart below investigates the development in USDMYR versus the credit spreads on the longest dated USD-denominated Malaysian government bond versus a US Treasury of similar maturity. It is arguable that the MYR should have weakened more than it has, given the widening spread. We suspect one offsetting factor in the MYR’s favour has been China’s maintenance of its strong and stable CNY regime.
COP: The Colombian election is set for this weekend – we’ll review the outlook next week as we are likely set for a second run-off poll in June. Oil, Colombia’s most important export, is under a bit of pressure later this week as headlines indicate that Opec (Colombia is not a member) sees an opportunity to ease up on its current production limits, at least partly a result of the catastrophic fall in Venezuelan production over the last year. There is a somewhat exogenous risk to Colombia from Venezuelan refugees, which have become a large liability for the country and could be made worse by the negative spiral in Venezuela, which has ironically not responded to the revival of oil prices that has dramatically improved Colombia’s external balance since early 2016.
Chart: Global Risk Index – still on the defensive even with pockets of eerie complacency
The risk appetite picture from our single global risk indicator remains unsupportive of exposure to risky assets and has dipped from the prior week’s reading. But the conflicting message from the various sub-components that comprise the indicator is the most interesting feature this time around. The “eerie complacency” in our headline is rather extreme quiet in FX, and especially US equity market volatility with the latter having virtually flat-lined since an important resistance line was broken on the S&P 500 chart.
FX volatility has only picked up slightly despite this week’s sudden dose of JPY volatility. Given current levels and the other components of our model flashing more notable signs of worry, we suspect that rising market volatility is a prominent risk in the weeks ahead.
Elsewhere, we note that junk bond spreads and credit indicators are stretching toward the worst levels for the cycle and emerging market credit spreads have not improved notably from their worst levels of late. Another indicator we are watching is the MSCI Emerging Market index, which is trading – in USD terms – below the 200-day moving average and right near recent lows and the lowest level of 2018.
EM Currency Outlook: US yields at key inflection point, but risk appetite focus could steal the show
Lately our focus on the downside risks for EM assets have been centered on the US dollar and rising US bond yields. This time around, we have a new twist on the situation, as the pressures from US yields have eased but other measures of risk have picked up notably as noted above in our discussion of the Global Risk indicator.
As well, there are prominent signs of flows leaving emerging market assets even before we have seen the latest versions of the most widely followed flow indicators, led by a pullout from Turkish bonds and equities (flows are mostly a coincident indicator, so the tough part is finding something predictive).
Some of the recent JPY strength – itself a risk-off indicator – may be down to an emerging market exodus.
Finally, regarding the commodity exporter theme we highlight above in the chart showing outperformance of commodity-linked FX, we would suggest that the oil market is possibly at a key inflection point now that Brent crude has traded at 80 dollars and is on its way back down in the second half of this week after Opec plus Russia have circulated the idea of increasing production to offset the drop in Venezuelan production of late. We have already been convinced that the global economy is facing a slowdown by later this year and the higher oil prices have underlined this risk.
Our strategy for allocating (long-only) exposure to emerging market is to start accumulating slowly during signs of an all-out rout in markets, where the washout provides a steeper discount in the highest quality EMs. Further along, we would look to add exposure more aggressively, also to the riskiest EMs once any major sell-off is behind us and the market is clearly on the mend. At present, we continue to sit on our hands.
EM currency performance: recent and longer term, carry-adjusted
Chart: the weekly spot and one-month carry-adjusted EM FX returns versus USD
The shortest term performance in EM currencies has turned flat to positive in most cases as the USD rally has eased – note the strong outperformance over the last week for the commodity exporting currencies relative to other EM peers.
Chart: three- and 12-month carry-adjusted EM FX returns versus USD
The longer term picture shows the Turkish lira firmly at the bottom of the class, but the chief contrast here is between the three- and 12-month performance in most cases as the EM relative weakness began almost four months ago when our Global Risk Indicator turned negative in early February.