EM FX Weekly: Global risk conditions work against EM

John Hardy

Head of FX Strategy, Saxo Bank Group
John Hardy joined Saxo 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.

Emerging market currencies continue to struggle as global risk conditions have become even more unfriendly over the last week. Although the recent negative spiral in the Turkish lira was halted for a time, we are seeing signs of worsening conditions for EM assets in our global risk measures and specific EM credit and equity developments, so we maintain a very cautious outlook. The renewal of the EU existential risk with the political situation in Italy is no help and it is not a situation with any quick fixes, even if the immediate risk of a crisis fades quickly.

EM developments over the last week

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

TRY: the Turkish lira has been one of the strongest currencies over the short term as the Turkish Central Bank followed up on its recent 300 basis point hike with a simplification of its various policy rates and promised to move toward a single rate. The situation remains tense ahead of the June 24 election as President Erdogan’s handling of the issue of central bank policy independence is a critical hurdle for a more sustained recovery in the lira, as is the country’s structural external deficit and heavy load of external debt (more in the banking system's exposure to foreign currency than in government sovereign exposure to same).

BRL: The Brazilian real is the worst performer in our EM universe over the last month. We have seen credit spreads widening in a number of the large EMs of late, but the worst aggravation of credit risk over the past few weeks has been in Brazil. The real has suffered on the overhang from the fiscal credibility issue centered on the country’s unsustainable pension outlays and whether and when the issue will be addressed (earliest seems to be after the October election and it is a thorny one with massive popular resistance to any austerity). In the meantime, a massive oil-worker and trucker’s strike broke out recently and resulted in shortages and tremendous disruption to the economy. The strike may be wounding down now, but headlines shouting the risk of a return to military rule aren’t particularly helpful and it is an awfully long wait for the next election.

Chart: Brazilian USD-denominated sovereign debt has been in for a rough ride over the last couple of weeks. The bond we chose for the chart below maturing in 2041 now yields more than 350 bps more than a US Treasury of similar maturity, up from well below 300 bps earlier this year. Worsening credit spreads are a significant driver in the real’s weakness this year.

MXN: The beleaguered peso also put in a weak performance over recent weeks on the ongoing trade tariff threats from President Trump as well as the sense that this is energising a populist revolt in Mexico as the countdown to the July 1 election gets louder and the left-populist Obrador looks to receive a strong mandate from recent polls. Mexico’s economy rests on a foundation of export-driven activity and the risk of a trade showdown with the US and any fiscal shenanigans from a populist leader are risks for the currency’s outlook, even if the peso is one of the cheaper currencies in our universe, adjusted for inflation.

IDR: The Indonesian rupiah has been the rare strong perform among EM currencies of late as the new Indonesian central bank governor has made a point of propping up the currency to avoid inflation risks. The bank hiked the rate 25 bps on May 30 – just two weeks after a prior hike and new governor Warjiyo has promised further hikes if necessary. The move has sufficiently impressed the market to boost forward rate expectations and has kept the rupiah much stronger of late relative to its Asian peers (note the performance charts below).

Chart: Global Risk Index – Beginning to look ominous if morale doesn’t improve

Our global risk indicator has taken a further acceleration to the downside recently, even if it has managed a marginal recovery from its worst levels intraweek. The situation is rather ominous as market volatility measures have yet to pick up in any major way. This despite the fact that warning signs elsewhere have turned rather urgent, from emerging market credit spreads pushing to the worst for the cycle (see Brazil above) to a dramatic recent episode of deteriorating corporate credit (although the latter has partially covered from an ugly recent spike that looks suspiciously correlated with the recent spike in EU peripheral sovereign spreads linked to Italy’s political mess).

Another strong concern for the outlook for EM currencies is not only the widening credit spreads (still modest relative to the historic record), but significant declines in EM equities that point to outflows from EM assets. Specifically, the MSCI Emerging Market index in USD terms recently slipped below its 200-day moving average, but this week the index has turned sharply lower (see below).

Chart: MSCI Emerging Market Index in USD Terms (chart courtesy of Bloomberg)

Note that this is a weekly chart in order to show more data – the 40-week moving average shown is the same as the 200-day MA. The break below the 40-week average is the most serious since the worst post-global financial crisis lows for EM in early 2016.

EM Currency Outlook: Concern level for EM has shifted a couple of notches higher

Our chief concerns for the EM FX outlook remain the weak global risk appetite backdrop. But as well, EM currencies have disappointed by failing to stage a more significant recovery after the solid adjustment lower in Federal Reserve rate expectations. We don’t think that the Powell Fed is trying to wax dovish in recent language shifts promoting the “symmetry” of response around the inflation target. Rather, we suspect that this is an attempt to shake the sense that the Fed is “pre-committed” to any course of action now that the 2 % inflation target has come into view, giving it more flexibility to respond either way based on incoming data.

Still, the recent Federal Open Market Committee minutes do give the sense that the bar is higher for the Fed to adjust rate expectations higher for the near term. So the risk of higher US yields may have faded for now as an EM headwind, but lower rates might not be particularly supportive if these are owing to weak US data. 

Of course, it is difficult to determine how much of the recent bout of weakness in EM was simply collateral damage from the rogue wave that washed over EU peripheral sovereign debt markets over the last week – but we’re not entirely convinced that it is the chief contributor to ongoing pressure on global risk appetite that keeps our caution level on exposure to EM assets high. If USD strength fades further from here with or without a drop in US yields as the global growth outlook turns higher again, there may be a window of opportunity for EM exposure, but we’re still sitting on the sidelines for now.

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

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

A Latin American duo scraping the bottom of the rankings this week as MXN struggles with Trump tantrums and the onrushing July 1 election and BRL has been buffeted by strikes and a much longer wait for October elections and the urgent need for fiscal reform.

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

The longer-term picture shows the Brazilian real giving the Turkish lira a run for its money in the race to the bottom, with the Russian ruble returns in the longer-term picture still dominated by the one-off move after new sanctions were announced back in early April while the near-term performance has been more resilient on the rise in oil prices this year.

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