A number of recent developments have supported EM trades, including large-scale new easing from the Fed, both in terms of the three rate cuts administered since the summer and the fresh expansion of the Fed’s balance sheet to the tune of $60 billion per month in T-bills on top of the large repo operations aimed at countering liquidity problems in the US banking system, at least in part driven in turn by the US . And no doubt about it, a weak US dollar is normally associated with heavy gains in EM currencies and assets. But we struggle with a bit of cognitive dissonance here if the US economy is indeed heading toward a recession, which would require more Fed easing. Up to this point, the market has largely celebrated the easier Fed, but at some point, a slowing economy is normally associated with widening credit spreads and safe-haven seeking, conditions not normally associated with positive EM asset/currency performance.
Chart: Saxo Bank Global Risk Indicator
Our global risk indicator recently peaked out at its highest reading since the remarkable conditions that prevailed for much of 2017 in which everything risk-correlated, particularly EM, did very well. This time around we have a hard time believing that similar conditions can endure on our suspicion that the US is heading for at least a minor recession, which is normally associated with weaker financial conditions, widening credit spreads, etc., basically all of the things that normally provide headwinds for EM assets and currencies.
An added wrinkle is the prospect of a US-Trade deal. Yes, US President Trump, as he eyes his 2020 re-election campaign, is likely very willing to walk back some of the US tariffs and make a narrow, transactional deal based on Chinese promises for large-scale agricultural and other purchases, but we see will be no profound, deeper deal between the two rivals, and a recent Bloomberg article even suggested that even the narrow deal could be endangered. Stay tuned for that and stay tuned for how the market treats US incoming data, especially of the weak variety.