Head of FX Strategy
Summary: At current levels of risk willingness and an historic reach for yield as central banks easing , we are reluctant to cheer risky assets on from the sidelines here at these levels. Interesting to note that EM currency performance has been a bit mixed as the New Year gets underway despite an incredibly supportive backdrop.
There hasn’t been any real shift in the market narrative for global markets since our post at the beginning of the year, in which we noted the supportive backdrop in financial conditions for emerging market currencies and risk appetite in general. Less supportive for the EM carry traders has been the fundamental story as the global growth story has generally failed to improve despite important signs of stability in some of China’s numbers, though that country has chosen not to indulge in the mass mobilization of a huge credit impulse as was the case in past cycles.
Emblematic of the mismatch in EM performance versus the growth backdrop is one of the ex-Asia star performers over the last month of FX action, the Mexican peso, as Mexico continues to show signs of stagnation. As noted below, the strongest performers were a select group (or we should say, an oddly select group) of exporting Asian EM currencies hanging on to the coattails of the strong Chinese renminbi, which saw its most notable strengthening move in almost two years ahead of and just to the other side of the US-China “phase one” trade deal signing last week. Some of our cautious outlook on EM from here noted in this outlook stems not only from what we see as over-complacent conditions for risk, but also as we suspect China may see little interest in driving its currency higher from these levels.
YTD EM Carry trade performance in 2020.
Below is a snapshot from a Bloomberg tool for measuring FX carry performance. We chose the four highest yielding of the more liquid emerging market currencies at the beginning of the year versus the four lowest yielding G10 currencies. This basket returned nearly 15% in 2019 – a performance that was certainly enhanced by the fact that 2019 got under way near the very bottom of the plunge in risk appetite on fears that a too tight Fed would end the bull market and trigger a recession. We suspect 2020 will fail to provide these heady returns for EM carry trades, though it is off to an excellent start at around 1.4% YTD, which projects to an unlikely annualized return of 32.25% - note that we used the MSCI EM equity index in USD terms as the benchmark this time.
Chart: Saxo Bank Global Risk Indicator
Hyper-generous liquidity provision by the Fed over the end of 2019 and now into early 2020 has the market celebrating the implications for global financial conditions as all major central banks are in easing mode. A prominent risk in the near term is that the Fed signals that it would like to slow the pace of balance sheet expansion, and another risk further out is that the global growth bounceback that is already thoroughly priced into risk assets fails to materialize. For now, however, our Global Risk Indicator is still near its all-time high – a level that by definition is difficult to maintain because it is based on deviations from a moving average, meaning that in a theoretical world of totally unchanged conditions in the underlying indicators (actually close to what we have seen for more than a month) would eventually see the indicator move to zero/neutral.
Carry trade performance*
The stronger US dollar is providing some headwinds for carry trades, but only modestly so, as the lowest yielding majors, EUR and JPY, have been relatively weak, while the CHF and SEK have proven less attractive as funding currencies as the Swiss national Bank last week was put back on the watchlist of possible currency manipulators by the US Treasury, sending EURCHF to new cycle lows, and SEK has enjoyed a bit of resilience as the Riksbank pulled its policy rate out of negative territory in 2019 and back to zero – where it has signaled it is likely to remain as far over the horizon as markets care to imagine.
EM currency performance is varied, to say the least, as China allowing/forcing its currency to trade stronger saw it posting the strongest performance over the last month in our universe, with some Asian EM exporters (IDR, MYR) impacted by that move while others (THB, KRW) weren’t. Elsewhere, LatAm currencies are all over the map, with MXN a notable strong performer, perhaps as it features one of the world’s highest real interest rates (CPI running around 3% while the policy rate has so far only been cut to 7.25%) Turkey is in a different place, now that it has cut its policy rate to 11.25% and thus below its most recent inflation print of 11.8% year-on-year. Brazil is struggling on fears that the US-China trade deal could divert a considerable portion of soybean demand from Brazil to the US.
Current carry available*
The chart below simply shows the forward carry for owning the USD versus funding currencies and the returns on higher yielding EM currencies versus the US dollar. EM policy rates will likely continue to drop if the financial conditions and currency volatility backdrop remain muted, but we still posit that the interest rate spreads are almost as low as they can go here, and any expansion would likely be on the return of market volatility and new concerns about the global outlook.
*Note that all performance calculations are done as carefully as possible to include trade spread costs and market conditions at the time but actual results will inevitably vary depending on the timing of rolling forward positions and other factors.
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