Big US yield break throws down the gauntlet for EM

John Hardy

Head of FX Strategy

Emerging market currencies saw a bit of relief at times over the last week as the USD rally paused, but then a fresh surge in the greenback and – more importantly – a break to near seven-year highs well above 3.00% in the US 10-year benchmark saw a fresh weakening in most EM currencies, leaving most with a weaker performance versus the USD for the week, though not particularly weak against other major currencies.

Among the more liquid EM currencies, we continue to focus on the Turkish lira as a special case if risk conditions worsen due to the country’s structural vulnerabilities, sharply worsening credit spreads, and the risk of capital flight ahead of the June 24 Turkish election.

EM news and views

It's no surprise that EM currencies remain under significant pressure from the twin threat of a strong US dollar and the entire US yield curve lifting higher, with the past week seeing the break to a new near-seven year high in the US 10-year benchmark above 3.05%. The weakness in EM has been somewhat tempered by relatively strong risk appetite globally, as despite EM currency weakness the MSCI emerging market index (in USD terms) has remained within the range of the last several weeks.

A rundown of specific EM currency developments:

RUB: the ruble is a standout performer on the positive side relative to other EM peers as the strong surge in oil prices supports from a current account angle. As well, Putin’s profile seems to have become less belligerent even as the geopolitical backdrop has continued to heat up; his focus in what may be his last term may turn out to be increasingly domestic.

TRY:
the Turkish lira continues to scrape bottom as President Erdogan is sending all of the wrong signals ahead of the June 24 presidential election. His latest pronouncement that he will become more closely involved in interest rate policy decision after his victory in June has sparked additional concern, especially as he has claimed that interest rates need to be lowered because high interest rates are the cause of high inflation. This is not the kind of interference that foreign capital would like to see and capital flight is a risk, particularly as some may fear some form of capital controls once Erdogan takes on the vastly expanded executive powers that the presidential office attains after this coming election. We maintain that a real negative spiral risk remains for the lira and such an event in one of the larger EM currencies could see widespread contagion across EM were it to unfold.

CNY:
China remains determined to keep the CNY firm relative to other currencies even as it has settled a bit lower versus the USD as the latter has strengthened. This has provided an anchor for the the most China-exposed Asian exporting economies, from South Korea and Singapore to Thailand and Malaysia, but it also leaves the market extremely vulnerable to a shock if China’s authorities take a different approach from here, particularly to the weak side should the USD strength continue. 

BRL:
the Brazilian real was a weak performer over the last week and month, only losing the race to the bottom relative to the Turkish lira as the country’s outlook seems to be stuck in a painful limbo until the elections in October, as sitting President Temer appears unable to push through key constitutional reforms needed to change the unsustainable budget shortfalls created by the excessively generous public pension system. Some see the weaker BRL as partially a result of contagion from the Argentine peso crisis, but the weakness appears justified given the fundamental structural vulnerabilities in Brazil and the EM-unfriendly backdrop. Remarkably, the Brazilian equity index remains very elevated and Brazil’s USD-denominated credit spreads have only widened modestly during this recent episode.

Charts: a selection of EM spreads

We reproduce our chart series from last week to show that, with the very notable exception of Turkey, the widening of EM credit spreads has partially reversed course, much more so than the underlying currencies themselves, making us wonder if currency hedging has come into play as much as, or more than actual reduction of exposure to underlying EM assets.

 
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IDR: the rupiah has weakened to new cycle lows versus the USD though it hasn’t underperformed Asian peers badly over the last week. The Indonesian central bank has responded appropriately with a 25 basis point hike to take the rate to 4.50% to defend against currency weakness. What is behind the IDR’s weak performance? We suspect the chief suspect could simply be Indonesia’s status as a king of EM Asia proxy, given its deep and liquid USD-denominated sovereign bond market and the popularity of investment over the strong portion of the EM cycle means that the IDR could remain somewhat vulnerable from a positioning perspective more than for any economically fundamental one.

MYR: the election surprise many as the sitting prime minister Najib’s political machine was unable to tilt the odds sufficiently and 92-year old former PM Mahathir has gained power, promising prosecution of the former PM and a recovery of funds said to be laundered by Najib through a controversial sales tax initiative. This is an historic moment for Malaysia, though it may not lend any support to the ringgit. The GST tax Mahathir has advocated abolishing and his promise to bring back fuel subsidies will aggravate fiscal deficit worries and will be a disappointment for foreign bond holders as the long record of improving fiscal prudence may be coming to an end here. The ringgit could suffer further weakness relative to its Asian peers in coming quarters.

CLP: We have noted our concerns on Chile over the last couple of weeks, though the currency has been in a holding pattern over the last week and likely needs a more notable specific catalyst - further contagion risks from Argentina or a sell-off in the copper price below 300 cents/lb. to show a pronounced underperformance relative to EM peers.

COP: The Colombian peso has come in for a weak performance over the last month despite the strong performance in oil prices (Colombia’s chief export, although the country has seen no notable discoveries in the last 25 years and is at risk of a natural gas supply crisis as its domestic NG production falters). Presidential elections are scheduled for next weekend on May 27, and if no candidate gains an absolute majority, a second round will ensue on June 17th. The outgoing President suffers a very low popularity rating of 13 percent as many are unhappy with the peace deal with the FARC guerilla group, concerned about corruption, health care and inequality, but also about the enormous numbers of Venezuelan refugees fleeting economic misery.  The current leader in the polls is the conservative former president Uribe who is divisive for many voters and is even under investigation for murder after the witness in a criminal investigation of Uribe was killed last month.

Colombia’s current account picture is improving rapidly with the price of oil and the growth rate has picked up. The COP looks reasonably valued and even slightly cheap, though we would still look for slightly deeper value for considering a long position.

Chart: Global Risk Index – EM not doing well, but it could certainly be worse

The risk appetite backdrop for emerging market currencies is not supportive, but it could certainly be far worse given our rather long laundry list of concerns. EM credit spreads are still elevated relative to their moving averages, but have come off the local peak over the last week, a development easily visible in our charts of specific EM USD-denominated bond spreads above.

In USD terms, the broad MSCI emerging market equity index has yet to break lower and market volatility measures remain thoroughly range-bound. We have a hard time believing that risk conditions will improve notably in the near terms as long as this break higher in US longer yields is afoot, though there could be room for a brief summer lull with high complacency if yields go sideways and economic data improves for a couple of cycles. That is perhaps the chief risk to our longer-term, more bearish outlook on the global economy.

 
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EM currency outlook: will higher US yields continue to tighten the noose?

In last week’s edition of this publication, we zeroed in on the US 10-year benchmark and the clearly etched line in the sand at 3.00% as a significant worry for EM if that line were to be crossed. Those worries proved well-founded so far and a mild extension in EM weakness has accompanied the new rush higher in US yields.

We note supportive evidence this week for our rather pronounced EM concerns: first, noted Harvard economist Carmen Reinhardt notes the increased structural vulnerabilities in many EM countries relative to past crises  and in a long podcast from Macrovoices, macro strategist Russell Napier makes a strong case for why the USD could continue to strengthen and EM could prove particularly vulnerable as real US rates must rise to attract the funds necessary to absorb the enormous US Treasury issuance this year.

Again, our longer-term outlook is weighed down by the worry that the global economic expansion will show clear signs of faltering within a year in China and the US, with other regions following with a lag. Adding significant pressure on global growth is the ongoing rise of crude oil prices, with Brent hitting 80 dollars per barrel as of this writing, a rise that has been even more aggressive in recent months in local currency terms for energy-intensive EM economies. With all of the above factors in mind, we would still like to see a further discount in EM assets – a real “risk off” washout – or to be proven wrong in our cyclical growth assumptions or to see the Fed moving away from further tightening (that appears far over the horizon) before advocating exposure to EM currencies.

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

Chart: the weekly spot and 1-month carry-adjusted EM FX returns versus USD

Despite the sea of red still in evidence on the short-term performance chart, do note that the one-week weakness has been more modest for the stronger of the EM currencies this week, with market leaders ZAR and RUB able to eke out positive performances. The MXN is this week’s worst performer as international investors fret the presidential election on July 1 and the likely victory of the populist Obrador (in addition to the background noise on NAFTA, which hasn’t led anywhere conclusive). Mexico is vulnerable on all fronts if global growth weakens as it has built up a large export sector over the last two decades.

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

The longer-term picture continues to show that most EM currencies have fallen versus the USD over the last few months after a prior period of quite strong performance that still leaves them up year-over-year in carry-adjusted terms.

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