Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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EM FX Carry Trade Update November 18, 2019
John J. Hardy
Chief Macro Strategist
Summary: Select South American EM currencies have suffered an ugly downdraft led by the Chilean peso recently on sudden social unrest while conditions elsewhere are rather less volatile. EM currencies are supported by still strong risk conditions, but central banks across EM are taking advantage of the conditions to chop policy rates, eroding the ability for investors to extract carry.
Despite what on the surface would appear to be a very supportive backdrop for emerging market currencies, EM currency performance has either been relatively indifferent or in the worst cases, absolutely terrible over the last three weeks. Some of the recent support for EM conditions and the more liquid EMs globally has come from very strong risk appetite as the market holds high hopes for the US-China trade negotiations and as the US Federal Reserve’s recent policy easing and resumption have been very welcomed, especially as a few of the more recent US data points have led to a narrative that the US may skirt recession or is stabilizing now from all of the stimulus.
The US Fed’s efforts do improve USD liquidity in general, all other things being equal. At the margin, another factor has likely been China allowing the USDCNY rate to cross back below 7.00 as China applies whatever goodwill pressure it can to get the US to drop tariffs in the ongoing trade negotiations.
Just before posting this, however, we are reminded of how fragile the trade deal narrative remains as a negative story breaking on a possible misunderstanding between the two sides has the USD moving higher and risk appetite suddenly swooning. One thing for sure, the general uncertainty has muted volatility as we await the outcome, though we are already likely priced for more than any trade deal can actually deliver. Likewise, the market is of course very poorly positioned for a fresh breakdown in talks akin to what unfolded earlier this year, when Trump jacked tariffs sharply higher.
Chart: Saxo Bank Global Risk Indicator
Before easing back lower a bit over the last couple of weeks, our global risk indicator recently saw some of the most positive readings in its history (remember, the readings for the indicator are never absolute, but rather merely based on standard deviations relative to a moving average, all with a 150 day look-back period.) Most interesting for EM traders, the EM credit spreads have been a major contributor to strong indications of risk appetite, and have absolutely collapsed at an incredible pace to within about 25 basis points of the lowest levels since the global financial crisis. Given that collapse, the short term performance of EM is not particularly impressive, with EM perhaps held back by the stubbornly strong US dollar and the recent back-up in US interest rates. If EM hasn’t put in a particularly noteworthy performance given a nearly historically supportive backdrop, it is hard to see what can support from here, save for some profound breakthrough in trade tensions or a broad upswing in the economic outlook.
Carry Trade Short Term Performance
The shorter-term performance of EM currencies was mostly down to the prior month, with some of the Asian exporters possibly bid due to China moving the USDCNY below 7.00 – note solid performance in the CNY (CNH) itself and similar performance in IDR, MYR, KRW. But South America has been socked with ugly losses, concentrated in a wild swing in the Chilean peso after social unrest recently broke out, but now Colombia’s peso now embroiled in a similar situation as a nationwide strike has been called for November 21.
A snapshot of specific EM credit spreads
We flashed the chart below the last time around (though this time we add the Chile and Russia charts at bottom), noting the recent back-up in South Africa’s credit spreads on the news of the ESKOM bailout effects on the nation’s budget deficit. Alas, one of the bond rating agencies’ decision not to downgrade South Africa’s sovereign bonds to junk may have saved the credit spread for now and ZAR has remained rather stable. Elsewhere, however, note how many currencies are “underperforming” the positive developments in individual spreads. This could be either a sign of an unrecognized opportunity, a sign that investors are waiting for more supportive signals from the US dollar turning lower, or a warning that EM’s are having a tough time catching a bid in a supportive environment and that policy cuts across EM are wearing on investors’ interesting in the sector. Note that the massive spike lower in CLP has in no way affected the country’s credit spread thus far – and we have seen a considerable bounce-back in the CLP from its weakest levels.
Carry trade performance*
Among the funding currencies, the sterling resurgence suggests carry traders should steer clear of funding in sterling if the path to a smooth Brexit remains clear through the December 12 UK election. Elsewhere, the USD has more than held its own against the other negative yielding funding currencies over the last month – especially versus the Euro.
As for EM Currency performance, the Turkish lira has been a darling , while elsewhere the performance has been more mixed, to say the least.
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. We have discussed in recent weeks how increasingly little carry is available as many EM central banks have taken advantage of generous financial conditions and low inflation to slash rates. Interesting to note that the two very weak performers in EM of late, COP and CLP, are in countries with some of the lowest policy rates across EM, suggesting little room for error when problems do arise.
* Note that all performance calculations attempt to accurately reflect trade spread costs and market conditions but actual results will inevitably vary depending on the timing of rolling forward positions and other factors.
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