EM FX Weekly: Relief rally may not have legs

John Hardy

Head of FX Strategy

We’ve seen a selective recovery in EM currencies and assets from new lows for the cycle. Buoyed a bit by a slight rebound in global risk appetite, by a slightly weaker US dollar and finally, by a strong move by Turkey’s central bank to short up the country’s currencies, emerging market currency performance has picked up sharply at the end of this week. But prominent risks remain, even if the situation calms further in the very near term.

Outlook for EM FX: Selective relief rally faces many obstacles

The EM outlook has improved on the surface lately as risk conditions have improved, and the very short-term outlook could remain benign for a time for select EM currencies with the usual caveats. These caveats are the usual suspects: first, that trade war fears remain at a simmer or even a lower temperature. Second, for EM to see a near-term rebound, the US dollar will likely need to trade sideways or weaker. Third, we have the question of US yields, which is perhaps the most difficult risk to gauge. 

Our thinking is that higher long US rates are deadly stuff for EM assets eventually, the question is merely one of levels, i.e. whether a break higher in the US 10-year Treasury yield above that key 3% level sees any immediate risk-off, or whether it is more the subsequent pace or extent of a further rise that slams on the brakes for any EM asset recovery.

By the way, on the specific question of the US yield curve and whether the Federal Reserve will dare to invert the curve, one couldn’t get a more clear message this week than the speech from Lael Brainard of the Fed’s Board of Governors, who made it clear that inversion isn’t something she fears.

Mostly isolated from the above consideration, we are also convinced that China would like to allow its currency to fall further from here, even if the US dollar remains rangebound or slightly weak – a sort of “Goldilocks CNY weakening” rather than a gap-wise or serve devaluation scenario that would unsettle markets globally. EURCNY and the 8.00 level is one to watch on this front if the USD remains somewhat weak, as is the broader renminbi basket and that level around 92.30. As China is the centre of economic gravity in Asia, a weaker CNY will weigh heavily on exporters into China like IDR, THB, KRW, and SGD.

Selected EM tidbits

TRY: Turkish President Erdogan finally allowed his central bank to get ahead of the market as the CBRT hiked the one-week repo rate this Thursday by a chunky 625 basis points, about twice what many believed was likely. The move saw the TRY able to rally and stick a strong close on the day of the meeting and this has been a key development in brightening the near-term outlook for the more fragile EM countries, even if we’re not convinced that Turkey is out of the woods yet.

RUB: The Russian Central Bank meeting today (and press conference still ongoing as this is being written) were pivotal for the ruble as the market had recently punished the currency on signs that the government would potentially interfere with policy, as it has twice called for easier credit and even explicitly hoping for rate cuts even after the ruble suffered ugly declines this year, stoking inflation. The rhetoric was especially worrisome as Russian Central Bank governor Nabiullina has recently weighed in on the need for rate hikes. At this Friday’s meeting, she actually moved to hike rates by 25 basis points, triggering a sizable RUB response as the market is reassured that she will do “the right thing” and continue to act with independence, although one can argue that a quarter-point move looks a bit meek. Elsewhere, the latest outlook for the interest rate is less pivotal than the risk of further sanctions against Russia from the US, possibly linked to the attempted Skripal assassination. We would give the ruble a wide berth for now even if it could rally in the short term back toward 65 versus the US dollar in sympathy with a broader recovery in EM.


USDRUB sold off steeply in the wake of the Russian Central Bank Governor’s brave rate hike despite the government’s leaning against further tightening. The Russian ruble was the second strongest performer for the week but is still down over 10% over the last 12 months on a carry-adjusted basis. Two-way risks remain prominent and are asymmetrically lower as Russia faces the risk of additional sanctions and many holders of Russian assets may have already lightened up – or will do so in the face of further RUB strength – to avoid the risk of having to liquidate holdings in an illiquid market if sanctions are announced.
Source: Saxo Bank
BRL: The Brazilian real headed to new lows for the cycle late this week even amid signs of a strong recovery elsewhere in EM. The runup to the first round of the Brazilian general election on October 7 has taken on new intensity with the near-fatal stabbing of the right-populist Bolsonaro, who has seen his lead fade in favour of the left-populist Haddad – though the latter is still only seeing 22% support in polls so the scenarios in the run-off round are still hazy.  BRL saw no real relief from the news that the popular, but jailed former president Lula was pulling his candidacy from the election this week. Haddad is the candidate for the PDT, Lula’s party. The BRL is beginning to look too cheap relative to Brazilian credit spreads – either the currency is wrong or the bond market is wrong.

: the quick trade deal between the US and Mexico’s lame-duck Nieto government saw a boost in the peso’s fortunes, but we see the MXN as getting a bit expensive relative to other EM currencies, even if it has room for rallying a bit further if the near-term outlook for EM risk appetite is benign. Although incoming president Obrador, who appears rather pragmatic for a purported populist, has been sending the right signals to the market, we’ll be on the lookout for measures that damage fiscal credibility once he is set to take office on December as the election gave him a strong mandate and super-majority in Mexico’s legislature.

: China has made good on its apparent intent to keep the USDCNY level capped, as USDCNY has traded in a tight range, still rather close to the 6.90-7.00 level. Elsewhere, we also note the 8.00 level in EURCNY for whether China will allow this well-defined point on the charts to fall. As well, we have the official renminbi basket floor near 92.30. More thoughts on the CNY in our general EM outlook below.

Global Risk Index

Risk conditions have improved sufficiently to take our Global Risk indicator well into positive territory. The indicators improvement was led most aggressively by the fall in equity and FX market volatility measures over the last two weeks, while EM credit spreads compressed and corporate credit spreads did likewise. The irony here is that these developments allow the Fed to continue to hike with abandon as Chair Powell has firmly pointed to financial stability as the key factor in pointing to a crisis. 
Source: Bloomberg, Saxo Bank
EM currency performance: Recent and longer term, carry-adjusted

Chart: the weekly spot and one-month carry-adjusted EM FX returns versus USD: The short-term performance chart below shows that the positive short-term EM FX stories have been positive indeed – led by two of the weakest performers this year, the Turkish lira and the South African rand. Note the Brazilian real’s inability to find positive contagion, while most Asian exporters also saw largely indifferent performance over the last week and month as the centre of gravity in the region, the Chinese yuan, has hardly budged over these timeframes.
Source: Bloomberg, Saxo Bank
Chart: Three- and 12-month carry-adjusted EM FX returns versus USD: The longer-term performance charts bring into perspective the magnitude of declines in Ems’ weakest performers and that Mexico is the outlier in EM – not the proxy it used to be.
Source: Bloomberg, Saxo Bank

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