EM FX Weekly: Dollar bulls continue their charge

John Hardy

Head of FX Strategy
John Hardy joined Saxo Bank in 2002 and has been Head of FX Strategy since October 2007. He focuses on delivering strategies and analyses in the currency market as defined by fundamentals, changes in macroeconomic themes, and technical developments.

EM currencies are in a real funk that has only deepened since our last report, as the strong US dollar has made its presence felt and the sector has undergone a large reappraisal in credit spread terms. A steep devaluation in the Argentinian peso and record lows for the Turkish lira have grabbed headlines, but the weakness has been persistent and broad-based and we have yet to see the light at the end of the tunnel, even if valuations in many cases are far more attractive than they have been for some time.

EM news and views

Besides specific currency highlights discussed below, emerging market assets and currencies have been exceptionally weak of late on the particularly ugly combination of a strong US dollar and a further rally in oil prices. The latter is a powerful headwind for EM growth prospects due to EM economies’ more intensive use of fuel per unit of GDP. But, as ever, the chief culprit for the broad-based recent weakness in EM has been one of capital flows, as investors are second guessing further allocation into EM’s and are even withdrawing funds in some cases.

Over the last week, the International Institute of Finance reported
 that EM bond and equity flows for the month of April were negative in aggregate for the first time since November of 2016, the month of the USD surge amidst Trump’s victory in the US presidential election.

Finally, we are writing this week’s report in the immediate wake of the US President Trump’s decision to reject the Iran JCPOA nuclear deal and revert to the prior status quo of sanctions. This has only aggravated volatility and raised the stakes for EM this week.

Charts: A selection of EM spreads

In this week’s chart focus, we chose a few of the weaker EM currencies and have charted them versus the credit spreads for their USD-denominated debt (yield versus the yield of a US Treasury note of similar maturity) to show that the worsening of EM credit is a specific negative driver for EM at the moment.

A couple of comments on the charts below: note that Chile’s credit spreads have suddenly worsened after a long period of quiet, that Brazilian credit spreads are oddly quiet (to us, given the tremendous structural risks to Brazil if the country doesn’t get its fiscal house in order soon), that the market has been reluctant to price in the sharp worsening in the South African credit spreads due to recent supposedly promising political developments, and finally that the Turkish credit spreads are basically as bad as they have ever been at a 400 basis point premium to US Treasuries maturing in 2040.

And now for our usual rundown of specific EM currency developments:

RUB: Putin has begun his fourth and possibly final term as Russian leader this week, promising a similar platform of improved productivity, growth, and social gains – all of which he has promised in previous years without much headway. To be fair, his prior term saw tremendous disruptions from a collapse in oil prices and geopolitical tensions triggered by everything from his decision to annex Crimea and the showdown in Ukraine to sanctions from the interference in the US election. The ruble has been very weak recently, but has escaped a more severe depreciation from this latest round of sanctions by the recent steep oil price rally. The ruble is one of the closer EM currencies to the “buy zone”, provided that the latest Iran news doesn’t deteriorate into a new showdown between major powers in the Middle East – a significant caveat.

TRY: the market was not impressed with the late April Turkish central bank meeting, the S&P bond ratings agency's downgrade of Turkish debt on May, nor the subsequent April inflation data (published May 3) showing core inflation rising above 12% year-on-year and likely to continue higher in the near future merely as a function of the currency’s depreciation and the economy’s reliance on key commodities imports. A negative spiral scenario driven by lack of confidence and poor liquidity remain a risk for this most vulnerable of the large EM markets, especially as Turkey is structurally vulnerable and has one of the highest risks of getting embroiled in any new geopolitical situation over the fate of Syria (and Iran’s involvement there and elsewhere).

CNY: The Chinese currency continues to react very slowly to the stronger USD, meaning that the CNY basket is actually rather firm against world currencies. Interesting to see how China plans to signal its intentions if the USD strength picks up pace further from here, as we see CNY as the world’s most overvalued currency run by a country that has vowed not to devalue it as a policy option. The next “technical” pressure point in USDCNY, if we can speak of such things in the case of CNY, is up toward 6.50, but it appears for now that China wants to keep CNY weakening at a very low beta to other currencies versus the surging USD.

INR: While the rupee weakness is ongoing and political uncertainties have returned, the FT reminds us of an important structural development that is key for India’s future economic development potential: the government widening its tax base. The Modi government’s rather harsh demonetisation push and new tax implementation is bearing fruit from a government tax revenue perspective that could bring the Indian government’s “take” up to global standards. The tax funds, if deployed wisely, can drive tremendous long-term benefits for the Indian economy via investments in under-developed public transportation, health, and education infrastructure. In addition, India has enormous upside potential via ongoing urbanization rate (the urban population in India is thought to be around 35% according to the CIA World Factbook, versus 55-60% for China and 80-90% for most DMs with reasonable amounts of arable land). As well, better productivity in its agricultural resources sector will increase food security. The only unfortunate aspect of the situation for EM investors is that the rupee remains somewhat expensive, though it has devalued some 10% from 2017 highs in real effective terms.

IDR: The rupiah has come further unmoored from its former trading range by the same ills affecting EMs everywhere, perhaps somewhat aggravated by the country’s current account deficit (around 2% of GDP) and a small miss on Q1 GDP growth, as well as fiscal deterioration risks linked to the country’s fuel subsidies.

MYR: Elections are slated for this week (May 9) and come with an ugly political environment with charges of corruption and gerrymandering aimed at tilting the ruling Barisan Nasional coalition’s chances. MYR volatility has picked up, but continues to show a strong link to the CNY. Is that stability versus the CNY deserved, or is China merely setting its rates according to other USD/Asian exporter exchange rate price action? The market is perhaps fretting the risks on the fiscal side from either of the two political options post-election, as both the sitting government and the opposition are trying to buy votes with the promise of handouts. The opposition, led by 92-year old former president Mahathir Mohamad, has even put the reintroduction of fuel subsidies back on the menu, as well as debt forgiveness for farmers. The country looks less vulnerable in structural terms than many others across EM, but its currency has become rather rich and over the last 10 years, Malaysia’s current account surplus has declined from 15% and higher to 2-3% over the last couple of years.

CLP: In last week’s publication, we discussed the development in recent years of Chile’s structural vulnerabilities in the form of a buildup of external debt and risk on the fiscal side as well. It appears this latest episode of EM pain, potentially aggravated by the proximity of Chile to Argentina and the latter’s recent woes, has finally seen the market reassessing CLP outside of its normal slavish correlation with copper prices. The latter remains a strong risk of the $3/pound threshold is taken out from here, but the jolt in Chilean credit spreads in sympathy with other EM credit indicators suggest that the weak CLP could linger regardless and we single out the currency for more near-term risks.

MXN: the latest political polls ahead of the July 1 presidential election suggest that the populist Obrador’s (a.k.a. AMLO) lead may not be shrinking as was thought on occasion recently. The energy level in MXN has picked up ahead of the vote, with one prominent journalist calling for the assassination of Obrador. For his part, Obrador has aired the idea of drug legalisation to fight the plague of drug trade linked murders in Mexico – something that is sure to raise the temperature of relations with the Trump administration if AMLO becomes the next president. Meanwhile, the outlook on the trade front remains dogged with uncertainty as Mexico’s export driven economy faces risks from ongoing NAFTA negotiations, which face a pivotal week ahead and have bogged down as both the US and Canada insist that wages in the auto sector in Mexico are too low.

Chart: Global Risk Index – EM spreads widen to worst since late 2016

No surprise to see that our measure of Global Risk has worsened again. Driving the worsening are a rise in our measures of market volatility – this time more in FX than in equities, and some worsening in one of our corporate credit measures as well as the emerging market credit spread widening we discuss above, as our broad EM spread measure rose to its highest level since late 2016 (again, no surprise that this coincided with the aggravated USD rally in the wake of the US presidential election in early November 2016).

While the heavy sell-off in EM does have us beginning to looking around for value, we are still concerned by getting involved too early as the 3.0% US 10-year level remains in play this week, a week that features the latest auctions of 10-year and 30-year debt, and the US 2-year yield is pushing on 2.50%. 

EM currency outlook: Still plenty of suspense as US yields and stronger USD remain a risk

The last time around, we discussed that the forward outlook for EM remained pivotal. It was indeed pivotal and EM has pivoted steeply to the downside, as the stronger USD and widening EM credit spreads have weighed on EM exchange rates across the board. But one key instrument with significant implications for EM that has yet to resolve up or down is the longer US Treasury yield, with the 10-year benchmark the usual focus. That benchmark has continued to hover ominously around the structurally important 3.00% area (six-year high is a few basis points above near 3.05%).

Higher US long yields are a strong risk for EM, particularly if these are seen as a threat to global risk appetite and not just EM. On the flipside, unlike so many other mini-cycles within the longer term cycle since the Global Financial Crisis, any significant move lower in yields may not prove particularly EM-supportive as the driver of lower yields more likely, this late in the cycle, comes down to concerns that economic growth is faltering.

Again, our longer term outlook is weighed down by the worry that the economic expansion will show clear signs of faltering within a year in China and the US, with other regions following with a lag. The recent spike in crude oil prices (even worse in local terms nearly everywhere due to the strong USD) is bringing forward this eventuality, particularly for EM. With this in mind, we would like to see a further discount in EM assets or to be proven wrong in our cyclical assumptions before getting involved in most EMs.

EM currency performance: Recent and longer term, carry-adjusted

Chart: the weekly spot and one-month carry-adjusted EM FX returns versus USD


Short term performance among EM currencies continues to show a sea of red with the race to the bottom somewhat surprisingly led by the Mexican peso and the Chilean peso over the last month, while the South African rand managed to steady over the last week after a miserable month.

 

Chart: three- and 12-month carry-adjusted EM FX returns versus USD

This time around, all of the currencies in our universe have slipped into negative performance territory over the last three months save for the KRW, which has likely been buoyed by the hope that some more profound peace is set to break out on the Korean peninsula.

Note that the Chilean peso has seen the most whiplash-inducing performance in recent months after a prior period of strength. The CNY (CNH here) has retreated all the way to a flat performance versus the USD over the last three months, while it is still 10% higher, carry-adjusted, versus 12 months ago.

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