The song remains the same: caution

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.

Conditions for EM currencies have deteriorated further as EM credit spreads have worsened again and the threat of trade wars has also jolted formerly resilient Asian exporting economies like Thailand and South Korea. The USD strength is no help, given the trillions in USD-denominated debt across emerging markets. We’re not hopeful that EM currencies are set for a sustained rebound any time soon and weakness is in fact broadening badly on the trade war theme. For the week ahead, the weakest link of all in major EM currencies, the Turkish lira, faces a critical test at the election this Sunday.

EM developments over the last week

A few specific EM currency developments for the EM currencies with the widest performance swings this week:

TRY: The Turkish lira weakened further even after the recent central bank move to defend the currency with an additional rate hike. The next week presents a major test for the currency on elections this Sunday, June 24. Has Erdogan’s popularity suffered enough with the recent currency turmoil to hand a more unified opposition the victory? The odds looks slim, but if the Ince-led opposition does prevail, the lira would likely see a one-off, massive recovery gap. Whether further TRY weakness is possible under an Erdogan victory, on the other hand, would largely depend on Erdogan’s policy steps, given prior signals that he would like to interfere with central bank policy. Just over this last week Erdogan indicated he would “deal with interest rates”. Not helpful. Credit spreads have widened perilously for Turkey’s USD-denominated debt in recent weeks and have worsened further over the last week.

BRL: The Brazilian real has stabilised since the Brazilian central bank promised to take the necessary steps to stem currency weakness via intervention in currency swaps, choosing not to reach for the interest rate level to bolster confidence in the currency as the economy limps along with 1.2% growth as of Q1, having emerged from recession just last year. Brazil is very reliant on exports and the threat of a trade war is a two-edged sword for the country as trade wars are bad for growth but could be very good for Brazil large soybean crop as prices for export to China could rise dramatically if China places high tariffs on its largest supplier, the US. Meanwhile, nothing has improved on Brazil’s political front, where the necessity of pension reform remains with no solution in sight and a long wait until the October election. As well, Brazil risks further aggravating its fiscal shortfalls by reinstating fuel subsidies to end the recent strikes.

Chart: Credit Spreads for Turkey, South Africa, Mexico and Brazil. Here we show the main driver of pressure across emerging market currencies, the widening of credit spreads that has shown no mercy for Turkey, Brazil and South Africa, even if the action in the actual exchange rates has been a bit more sideways than the spreads in some cases as authorities intervene. The credit spread for Mexico actually improved slightly over the last week, allowing a modest bounce for MXN, but the July 1 election looms there.

MXN. The Mexican central bank is set to hike rates this Thursday, according to consensus expectations, and Mexico’s credit spreads have avoided the widening over the last week that was in abundant evidence elsewhere. This despite the prospects for a resounding mandate for left populist Obrador at the upcoming July 1 election.  Stay tuned – the peso will be in focus over coming weeks as a traditional EM bellwether.

ZAR: Vying with the Turkish lira for the unenviable position as weakest currency of the week is the South African rand, which has likewise flat against the US dollar in carry-adjusted terms for the last 12 months. It seems the hopes that new president Ramaphosa would usher in new promise for the country have proven premature, though the bulk of the ZAR weakness in recent months is down to South Africa’s external imbalances and a very unfriendly market backdrop that has weakened all of the more vulnerable EM currencies. Credit spreads for South African USD bonds are now wider than they were at their worst levels in the final weeks of former president Zuma’s rule. South Africa’s economy is geared for commodity exports, and the recent large dip in gold together with a central bank chief vowing not to respond in knee-jerk fashion to currency weakness are further causes for concern.  

Chart: Credit spreads for Russia, Chile, Indonesia and Malaysia
Russian spreads have widened only modestly and Chile’s have remained orderly, though this last week’s steep sell-off in copper deserves our attention. The recent sharp rise in copper prices is linked to strikes at Chile’s huge Escondida mine, so if copper prices are high, it may be linked to reduced Chilean production, while if they are low, it is Chile-negative on the risk to this most import of exports. We have previously highlighted Chile's deteriorating external imbalances. The country is in far better state than many of its EM peers, but has largely got a free pass that could be in for a reality check on a drop below the key three dollars per pound level. In Asia, we see that Indonesia’s strong response to a weaker currency has offset a widening of the credit spread, while the Malaysian ringgit has dropped slowly against a stronger USD as its credit spread has widened in recent months.

THB: The Thai baht was in for a sudden decline this week, knocked lower as the trade tensions between the US and China flared suddenly again on Trump’s threat to  impose still steeper tariffs. As well, a couple of recent data points out of China have disappointed. In this case, a weak baht is less about the concern of default on external imbalances, and more about weakening growth and flows seeking other shores as Thailand’s large current account surplus at some 8% of GDP might be threatened in a China slowdown scenario.

KRW: Perhaps the single most vulnerable economy to any downside risk in Chinese demand from a slowing economy (whether intentional due to China’s declared intent to deleverage the economy or due to the implications of a China/US trade war). Disappointing China data this week and the Trump/China threat and counter-threat routine finally had USDKRW up sharply from its sustained bout of oscillating around the 1070 level all year. 

Chart: Global Risk Index – risk conditions worsen further
Our broad Global Risk indicator saw further declines, with intensification of EM risks noted in the slowly worsening EM credit spreads (see more in our chart of individual spreads above) and a strong US dollar, while corporate credit indicators continue to show strain, even if they are still within a jumpy range established over the last several weeks. Market volatility measures have also picked up slightly after a recent lull to local lows. It’s been a long bout of risk off for EM, but the 2014-16 episodes provide perspective on how drawn out these can be.

Source: Saxo Bank

 
EM Currency Outlook: The FOMC could bail out EM for the short to medium term, but will it?

The conditions for emerging markets have not been friendly since our last report. As noted above in our coverage of the Global Risk Indicator, the EM-specific credit spreads have worsened and USD strength is no help. And as we have discussed in earlier reports, whenever US yields dip, it is for risk-unfriendly reasons like those owing to the blowout in Italian yields over the formation of the populist government there, or less dramatically this week on a dip in risk appetite and possibly due to the threat to Merkel’s leadership in Germany. 

The Federal open Market Committee meeting was somewhat supportive as the Powell Fed failed to raise market expectations for any acceleration in the pace of further rate hikes. But as we outlined in last week’s report, the Fed seems more intent on signalling a shift to a more flexible stance and moving away from relying on forward guidance so that it can react to incoming data without tripping over its guidance now that a more neutral Fed funds rate is coming into view (arguably around 2.50%).

Adding to the pain over the last week or so has been the sudden realisation that the threat of trade wars (and on the margin recent data misses out of China) is a significant threat to the economic prospects for Asian EM exporters whose economies are leveraged to exports to China, even if their balance sheets are relatively solid. So the broadening of the EM pain has been perhaps the most notable recent development. In light of the mix of developments, therefore, we would like to see either a steep further discount in EM currencies on a disorderly deleveraging scenario or a marked improvement in the macro backdrop before looking for exposure to EM as an asset class.

EM currency performance: Recent and longer term, carry adjusted

Chart: the weekly spot and 1-month carry-adjusted EM FX returns vs USD 
The South African rand has been the weakest performer over the last week and month as the market has unwound the premium associated with the removal of former president Zuma and his replacement with Ramaphosa and as the South African Reserve Bank has signaled no desire to react to currency weakness with policy tightening. On the plus side, MXN has managed near term resilience as Banxico is expected to hike rates this week. 

Source: Saxo Bank

Chart: 3-month and 12-month carry-adjusted EM FX returns vs. USD 

None of our EM Currency universe has risen against the US dollar over the three-month time horizon, though the Indonesian rupiah has done the most to avoid weakness in responding aggressively with rate increases. 

Source: Saxo Bank

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