EM FX Carry Trade Update October 22, 2019

The global market conditions can hardly get more support for emerging market assets, as the US dollar has weakened, risk sentiment is strong as global equities run higher, and credit spreads of all stripes compress. And emerging market currencies and assets have responded to the backdrop with solid rallies, nearly across the board. Still, we have a hard time believing that the sailing will remain completely smooth from here if the US is in for some kind of recessionary landing for its economy in the quarter to two quarters ahead. Sure, US economy weakness could bring powerful easing from the Fed and new balance sheet measures, all measures that would wear on the fundamental support for the US dollar.  But US recessions are normally associated with rocky conditions for equity markets, credit spreads and risk assets in general, hardly a menu of factors supportive of EM assets and currencies. Given the mismatch in expectation versus what we fear the reality might prove for the US economy and risk assets, we are a bit cautious here, while recognizing that there isn’t a jot of fear out there for the outlook for EM assets.

Chart: Saxo Bank Global Risk Indicator

Our last report came just as risk conditions were improving from a sudden dip in risk conditions and this one arrives with risk conditions about as supportive as they possibly can be for emerging market assets and currencies. Our global risk indicator rarely heads above a positive 1.00 for any length of time and we are close to that level now. From here, the next tests for emerging market-asset supporting risk sentiment will include:

• Whatever form a US-China trade deal takes, if any. Perhaps already priced is some sort of very narrow, transactional deal with the US side climbing down from some of its tariffs while China promises to make large purchase of agricultural and other products. Huge upside surprise, but slim odds, if the deal is more comprehensive in nature, something we see as unworkable as the natural rivals are not likely to come to terms on national security and technology transfer issues.
• How the Fed continues to position its balance sheet operations and the rate outlook at the next FOMC meeting on October 30.
• US incoming data. Material weakness in the US economy would likely see the Fed chopping very quickly – by fifty basis points per meeting – but the Fed chopping very quickly is historically in response to severe distress in market- and financial conditions, so by itself, Fed easing does not necessarily mean that EM assets would celebrate. Historically, it also takes time for the market to feel comfortable that the Fed is getting ahead of the curve and providing sufficient easing to turn sentiment back higher as a recession plays out.
• At the margin, whether the Bank of Japan is able to impress with any new measures it takes at its October 31 meeting after promising a policy review the last time around. The BoJ can’t really do anything in our view on the interest rate front and may only add to futile asset purchases at the margin.