EM FX Weekly: After the storm

John Hardy

Head of FX Strategy

This is the third release of our beta of a new weekly publication covering the performance and outlook for a number of emerging market currencies. We place particular focus on carry adjusted performance as carry is an under-appreciated portion of returns in EM currencies, while the spot exchange rate relative to past levels often provides little perspective, especially for the highest yielding currencies.
 
The weekly wrap: Emerging markets on the defensive after sudden equity meltdown
 
Last week we noted concerns that the bout of global risk aversion could lead to further weakness in EM currencies. But over the past week, risk appetite has come roaring back in global equity markets and EM currencies have broadly performed well, too. As also noted last week, perhaps the most remarkable feature of this entire recent bout of volatility was the degree to which EM currencies themselves, as opposed to the underlying equity and bond markets, saw very little of the contagion – it appears that equity market contagion is very high-risk in the event of a sudden meltdown like the one at the beginning of this month, but credit, whether corporate credit measures or sovereign credit measures in EM, saw a far more muted response and the latter has been rather quick to calm.
 
EM currency outlook 
 
Volatility has settled considerably over the last week, though the recent episode was sufficiently violent to make many, including ourselves, wonder if we are entering a new era of higher volatility now that this event has discouraged self-reinforcing volatility selling as a viable investment strategy after absurdly successful returns for the prior two years. As well, the fairly aggressive lifting of the entire US yield curve is a new twist that has to increase uncertainty and volatility at the margin in our debt-addled global economy.
 
The narrative for emerging market assets is rather difficult here. Normally, the rising US yields would be a strong warning signal for emerging markets as an indicator of tightening liquidity for the world’s dominant reserve currency, with trillions in USD-denominated exposure the world over. But this time around, higher US rates are accompanied by a weakening US dollar, reflecting concerns about a worsening US current account deficit under Trump’s new tax regime. That is a palliative to the rising rates concern, though at some level we suspect a persistent rise in yield would upset the entire apple cart of risk, as we discuss below.
 
A few observations that are occupying our attention for the coming few weeks and makes us reluctant to signal the all-clear for diving back into emerging markets:
 
   • Last week saw a higher than expected US CPI release that some worried would trigger both higher US yields on the fear of an even more hawkish Federal Reserve, and weaker risk appetite due to the risk that higher yields are seen as anathema to equity multiples. The reaction was rather interesting, as bond yields did rise rather sharply and to new highs for the cycle, but risk appetite quickly recovered. This is of course encouraging for risk-takers in EM and otherwise, but we are getting close to a key inflection point on the US 10-year yield benchmark – the six-year high just above 3.00%. At some yield level, higher yields will matter very much. And this week is an interesting one for the US treasury market, as the US will auction enormous allotments of two-, five-, and seven-year treasuries. Strong auctions could suppress US yields, but now that the market response has gone upside down on the reaction function to higher US yields, would a strong US Treasury auction see a stronger USD/weaker EM for the near-term on the flow implications?  
 
   • We are closely monitoring the US-China trade rhetoric as the Trump administration has circulated ideas on imposing tariffs on Chinese steel and aluminium. Regardless of the specific size of these imports into the US, any strong sign that we risk a dangerous showdown over trade issues is a massively negative event for global risk. Our spotlight currency this week on that note is the Chinese yuan (see below).  
 
   • EU existential concerns have been well off the radar since the Dutch and French elections of last spring, and perhaps deservedly so. But a small dose of caution is perhaps warranted until the market navigates to the other side of the Italian election on March 4th and potentially far more important, the March 4th German SPD vote on whether to approve the SPD party leadership’s Grand Coalition deal with Merkel’s CDU/CSU. The latest polling show the SPD with its weakest showing ever. A German political scene that is suddenly thrown into disarray could be Germany’s "Trump/Brexit" moment and lead to a bit of soul-searching in the longer term, even if the immediate implications aren’t entirely obvious or dire. This is a wild card, but deserves mention. 
 
Otherwise, if market conditions continue to settle and the US long yields remain relatively tame, the conditions for renewed strength in EM currencies would remain favourable.
 
Chart: Global Risk Index
 
The chart below is a Global Risk indicator which offers a perspective on the short-term level and momentum of risk appetite. At present, we are seeing a sharp recovery in the index as market conditions have calmed considerably in the wake of the recent eruption of risk aversion. FX volatility is the Global Risk Indicator input that has calmed the least, however, perhaps as USDJPY crossed below a big level recently, sparking a rise in JPY volatility.
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EM currency performance: Recent and longer term, carry adjusted

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

The chart below shows the sharp recovery in most EM currencies versus the USD as risk appetite rebounded in the aftermath of the equity market-centered volatility event. The ZAR remains a star performer as former president Zuma resigned. Keep an eye on the South African budget announcement this Wednesday for whether the rand can sustain this momentum as now the hard work for South Africa begins. Note that the Brazilian real is a bit of a laggard in the one-month time frame as President Temer struggles to reform the disastrous and unsustainable Brazilian pension system – a critical step for brightening the structural outlook for Brazil.
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Chart: Three- and 12-month carry-adjusted EM FX returns versus USD
 
In the three- and 12-month perspectives, the recent recovery in risk appetite has helped the picture.
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Spotlight currency this week: CNY (Chinese yuan)
 
Due to the general dollar selloff and higher fixings of the official guidance rate by the People's Bank of China, the yuan is close to its highest level since Q3 2015 versus the US dollar and up about 2.5% so far ín 2018. Against the government’s official, trade-weighted currency basket, the CNY is stronger as well, trading above the low-volatility range established in 2017. The prior consensus expected the yuan to weaken versus the US dollar as the Fed sticks to a policy tightening path while the Chinese currency seemed overvalued on a broad effective basis. 
 
But the dynamic of the US dollar has changed as Fed rate hikes are not seen as compensating for a deteriorating US fiscal and current account outlook after Trump’s tax reform. The question from here is whether the CNY should continue to appreciate on a broad basis as it looks too strong by a number of basic valuation measures.
 
One factor that could see the yuan turn lower soon is the prospect of lower China’s GDP growth. More and more data out of China corroborate our view of an economic slowdown in coming quarters. Our favorite indicator – the credit impulse, which leads the real economy by nine to 12 months – is in contraction for China. The Hong Kong merchandise trade volume index, which serves as a good proxy for Chinese trade due to its intermediary port position, has also been pointing down since early 2017. In addition, a surprisingly large number of infrastructure projects have been stopped or cancelled since the 19th Congress in a move to focus on the quality over the quantity of growth (such as in Inner Mongolia). This will have negative ripple effects on the private sector and ultimately on growth since these infrastructure projects represent around 20% of total fixed asset investment.
 
In terms of China’s monetary policy, the status quo is expected in the short term. The PBoC hiked the official medium-term lending facility slightly, from 3.00% to 3.25% in 2017 as part of a number of efforts geared to deleveraging the economy. Some slight adjustments this year could be made as a result of lower growth to ease conditions, and one might watch short term repo rates for signs of this, but the chief question for currency traders is one of pass-through from policy.

With the arrival of tighter capital controls in China in 2017, China continues to essentially just gets what it wants in terms of the exchange rate and it has wanted a stronger rate, possibly to avoid a lack of domestic confidence in the currency that was a problem in late 2015 and into 2016 and possibly with one eye abroad to avoid a confrontation with the US over trade issues. But from these levels, it is difficult to see why China wants its very strong currency to trade still stronger and any further deterioration in the USDCNY rate might be far more USD-driven rather than China-driven.

Chart: USDCNH and the official (CFETS) CNY reference basket
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In 2015 and 2016, global fears concerning China focused mostly on capital outflows and fears of a yuan devaluation, especially after the sharp revaluation in August of 2015. But since the peak in the USD in 2017, the renminbi has rallied almost 10% versus the US currency. For reference, we show China’s official reference basket, which shows that the currency has been rising broadly as well this year (the USD only retains a 22.4% weight in this basket).  

The structural issue for the yuan this year, which has not been priced in by the market, is clearly not linked to capital flight but rather to the risk of uptick in US-China trade tensions. Over the past weeks, the USA and China have taken a more aggressive stance on trade policy, threatening and counter-threatening after Trump’s team has circulated tariff ideas on steel and aluminium. An escalation cannot be ruled out and could see a very different stance on currency from China if Trump follows through on his threats.

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