NY Open: Watching paint dry
Traders are on tenterhooks ahead of the release of the latest FOMC meeting minutes later today. They shouldn't bother. Fed board members have repeatedly flown the dovish flag in recent days, so why expect surprises?
Head of FX Strategy
EM currencies were all over the map over the past week, as China halted the precipitous slide in the renminbi just as it was showing signs of accelerating through key support. The boost to sentiment was somewhat minimal for the rest of EM as the US-China confrontation over trade hits a new phase with the actual start of tariffs this week. Elsewhere, the MXN was a stellar performer while most EM currencies in our universe remain in a bit of a funk, although risk conditions have improved slightly and the threats from a stronger US dollar and rising Fed expectations have been dormant over the last few days ahead of the latest US jobs numbers.
EM developments over the last week
EM currencies saw sharply diverging performances over the last week. Some individual highlights:
CNY: China intervened in the currency market this week to prop up its currency, which had fallen over 4.5% in short order versus the US dollar recently, a move we noted last week would begin to destabilise global markets if it continued at anything approaching that pace beyond the 6.70 level in USDCNY. The intervention unfolded the day USDCNY crossed above that 6.70 level. Speculation has been rampant on the degree to which this is China “weaponising” FX policy to push back against the US in their trade confrontation. Alternative explanations are that this is a sign of China’s weakness or even that the US is weaponising the US dollar to squeeze the Chinese economy. We’ll not indulge in speculation of this stripe at the moment, even if the potential for this kind of rationale picks up if tensions escalate. For now, we merely note that USDCNY has yet to break the bounds of the range and would need to threaten 7.00 to really turn up the heat for EM and for global markets. The most interesting scenario from here would be one of further USD strength, as this would eventually force China to allow the 7.00 level to give or to force the CNY stronger versus the rest of the basket to avoid this eventuality. Meanwhile, the most complacent assumption is merely that China would like to discontinue its policy of maintaining a decidedly strong CNY policy relative to other currencies in the CFETS-defined basket and has now largely achieved this.
This week, the sharp move higher in the USDCNH (the offshore version of USDCNY), the largest since the August 2015 shift in China’s exchange rate regime, was halted just as USDCNY was crossing above the 6.70 level. The exchange rate is a nonfactor if the CNY stays in a range, but China has clearly at minimum ceased its “strong CNY” policy at the margin, likely to absorb some of the impact from trade tension, but also as its monetary policy needs diverge completely from those of the Fed as China is in an easing mode while the US Fed tightens. Two scenarios of interest from here: there is the scenario of USD strength we mention above and whether China allows the USDCNY to reach toward the top of the range and beyond. Another scenario is one in which the USD has topped and begins to weaken again – in which case the focus will likely zero in on whether China continues to weaken its currency versus the basket.
BRL: the Brazilian real stands out for its relative weakness. Weighing on the currency, besides the ongoing political dysfunction we have noted in previous weeks, are ugly price developments for a number of Brazil’s major exports, including coffee and sugar, both of which are currently trading near 10-year lows. Iron ore prices are also weak and Brazil is particularly vulnerable in any trade war scenario that weakens China’s economy as China is far and away its largest export destination (around 19% of exports in 2016). The one positive note would be that China’s tariffs on US soybeans could boost prices for Brazil’s soybeans – exports of which were more than 10% of Brazil’s total exports in 2016.
MXN: topping the EM performance charts this week has been the peso, as the market has decided that incoming president Obrador is no immediate threat to the currency and the young administration has sent market friendly signals, like promising not to roll back prior reforms allowing foreign investment in Mexico’s energy sector. Still, policy moves from Obrador will bear close watching for MXN traders as his coalition controls both houses of Mexico’s Congress and once all votes have been tallied (not yet there as of this writing), could see Obrador controlling a two-thirds majority that allows for constitutional reforms. This is a powerful presidency – ad hoc policy headlines risk making a large impact – with the risk skewed a bit more negative rather than positive at the moment, given the peso’s solid recent bounce off of lows.
CLP: the Chilean peso has been weighed down by the ugly decline in copper prices, which have slipped far below the pivotal three dollars/lb. level, trading near $2.80 as of this writing. Given that copper is far and away Chile’s most important export, this presents further danger of a decline in the peso’s fortunes. And, as we have noted that Chile’s external debt position has worsened materially in recent years, the credit spreads versus DM debt look complacently tight. Stay tuned – still lower copper prices could drive further CLP declines.
Chart: Global Risk Index – risk conditions worsen further
Our broad Global Risk indicator eased away from its worst levels, as the recent worsening of the broad EM credit spreads has yielded to a more sideways tendency, our corporate credit measures were mixed, and volatility measures pulled back lower after a recent modest bounce. The market is likely very happy to see China’s intervention after a rather scary sharp weakening in the renminbi. Still, we’re reluctant to believe that the market is set to launch into a major risk-on move from here. Friday of this week, July 6, marked the beginning of the actual trade showdown between the US and China with the first $34 billion in mutual tariffs. And US President Trump is out on the campaign trail and finding receptive crowds as he continues to rail against China on trade. On his way to a recent campaign event in Montana, according to CBS news, Trump said on the subject of tariffs that “We have $34 billion tonight, then another $16 billion in two weeks,” “And then as you know we have $200 billion in abeyance, and then after that $200 billion, we have $300 billion in abeyance.” As if that wasn’t enough, he added “It’s only China,”.
EM Currency Outlook: CNY and US data in the spotlight next week
There is something disquieting rather than encouraging about the market’s current complacency this week despite the backdrop of developments – particularly the ongoing threat of deepening trade tensions as US and Chinese trade tariffs went into effect this Friday. But any rally may be of a modest scale and only a result of a lack of fresh bad news rather than new positive developments during the slowest of the summer months of July and August. With Trump on the campaign trail, we can count on inflammatory rhetoric on trade regardless of the market’s reaction function.
Besides inflammatory trade talk and the risk it brings to global risk appetite, the other two chief risks are from the CNY and from the US dollar. As of this writing, we haven’t had a look at the June US jobs and earnings numbers, but the very strong ISM surveys and FOMC minutes this week failed to shift Fed expectations even a notch higher and the US dollar is on its back foot locally.
The FOMC minutes released this week did more prominently mention the risks from tariffs and a flattening US yield curve even as they noted a very strong economy. But given the very strong activity and inflation numbers in the US (next week’s June US CPI expected to see the core matching the post-GFC high of 2.3% YoY), it looks more than a bit complacent to us that the market has not priced even 50/50 odds of the Fed moving twice more this year (in other words that the Fed is seen more likely to only hike once more this year). The next important Fed-related event risk is the July 17-18 semi-annual testimony by Fed chairman Powell before congressional committees. This event should provide a sense of the degree to which trade tensions are unsettling the Fed leadership or raising the potential for the Fed to back off from its forecast trajectory of rate hikes. We think Powell prefers to look at the actual data in front of him, which points to higher US rates rather than lower ones – a decided headwind for Emerging Market assets.
EM currency performance: Recent and longer-term, carry adjusted
Chart: the weekly spot and 1-month carry-adjusted EM FX returns vs. USD. The Mexican peso more than sticks out on the positive side in our recent performance table with impressive gains over the Mexican election. The peso is often considered an EM bellwether, though that’s not the case this time around as the currency is very much doing its own thing. And most emerging market currencies saw little change or more negative tendencies over the last week.
Chart: 3-month and 12-month carry-adjusted EM FX returns vs. USD
Commodities exporters are prominent among the currencies at the bottom of the 3-month rankings in our EM universe and the Brazilian real is somewhat unusual in that its aggregate weakness over the past year has been concentrated over the past three months as the market has wakened to its structural weaknesses and the political uncertainty. At the top of the performance chart are the two currencies in our universe running a managed rate versus the US dollar (HKD and PEN) hardly impressive. It will be interesting whether Peru will persist with its stable, managed level if copper and gold prices continue to weaken and the USD is stronger as copper looms large in Peru’s export mix, if not as as large as for Chile. From late 2014 to early 2016, USDPEN devalued from about 2.80 to over 3.50 before settling into a 3.20-3.30 range since early 2017.