Emerging market currencies saw a bit of relief at times over the last week as the USD rally paused, but then a fresh surge in the greenback and – more importantly – a break to near seven-year highs well above 3.00% in the US 10-year benchmark saw a fresh weakening in most EM currencies, leaving most with a weaker performance versus the USD for the week, though not particularly weak against other major currencies.
Among the more liquid EM currencies, we continue to focus on the Turkish lira as a special case if risk conditions worsen due to the country’s structural vulnerabilities, sharply worsening credit spreads, and the risk of capital flight ahead of the June 24 Turkish election.
EM news and views
It's no surprise that EM currencies remain under significant pressure from the twin threat of a strong US dollar and the entire US yield curve lifting higher, with the past week seeing the break to a new near-seven year high in the US 10-year benchmark above 3.05%. The weakness in EM has been somewhat tempered by relatively strong risk appetite globally, as despite EM currency weakness the MSCI emerging market index (in USD terms) has remained within the range of the last several weeks.
A rundown of specific EM currency developments:
RUB: the ruble is a standout performer on the positive side relative to other EM peers as the strong surge in oil prices supports from a current account angle. As well, Putin’s profile seems to have become less belligerent even as the geopolitical backdrop has continued to heat up; his focus in what may be his last term may turn out to be increasingly domestic.
TRY: the Turkish lira continues to scrape bottom as President Erdogan is sending all of the wrong signals ahead of the June 24 presidential election. His latest pronouncement that he will become more closely involved in interest rate policy decision after his victory in June has sparked additional concern, especially as he has claimed that interest rates need to be lowered because high interest rates are the cause of high inflation. This is not the kind of interference that foreign capital would like to see and capital flight is a risk, particularly as some may fear some form of capital controls once Erdogan takes on the vastly expanded executive powers that the presidential office attains after this coming election. We maintain that a real negative spiral risk remains for the lira and such an event in one of the larger EM currencies could see widespread contagion across EM were it to unfold.
CNY: China remains determined to keep the CNY firm relative to other currencies even as it has settled a bit lower versus the USD as the latter has strengthened. This has provided an anchor for the the most China-exposed Asian exporting economies, from South Korea and Singapore to Thailand and Malaysia, but it also leaves the market extremely vulnerable to a shock if China’s authorities take a different approach from here, particularly to the weak side should the USD strength continue.
BRL: the Brazilian real was a weak performer over the last week and month, only losing the race to the bottom relative to the Turkish lira as the country’s outlook seems to be stuck in a painful limbo until the elections in October, as sitting President Temer appears unable to push through key constitutional reforms needed to change the unsustainable budget shortfalls created by the excessively generous public pension system. Some see the weaker BRL as partially a result of contagion from the Argentine peso crisis, but the weakness appears justified given the fundamental structural vulnerabilities in Brazil and the EM-unfriendly backdrop. Remarkably, the Brazilian equity index remains very elevated and Brazil’s USD-denominated credit spreads have only widened modestly during this recent episode.
Charts: a selection of EM spreads
We reproduce our chart series from last week to show that, with the very notable exception of Turkey, the widening of EM credit spreads has partially reversed course, much more so than the underlying currencies themselves, making us wonder if currency hedging has come into play as much as, or more than actual reduction of exposure to underlying EM assets.