EM FX Weekly: USD, US yields pause... but can EM revive?

MYR: the ringgit has remained stable and difficult to differentiate with the performance of the CNY over the last week, despite the unfolding political revolution and the risk to the fiscal balance from some of the measures proposed by the newly elected (92-year-old former) president Mahathir. 

Chart: USDMYR versus USD

The chart below investigates the development in USDMYR versus the credit spreads on the longest dated USD-denominated Malaysian government bond versus a US Treasury of similar maturity. It is arguable that the MYR should have weakened more than it has, given the widening spread. We suspect one offsetting factor in the MYR’s favour has been China’s maintenance of its strong and stable CNY regime.

COP: The Colombian election is set for this weekend – we’ll review the outlook next week as we are likely set for a second run-off poll in June. Oil, Colombia’s most important export, is under a bit of pressure later this week as headlines indicate that Opec (Colombia is not a member) sees an opportunity to ease up on its current production limits, at least partly a result of the catastrophic fall in Venezuelan production over the last year. There is a somewhat exogenous risk to Colombia from Venezuelan refugees, which have become a large liability for the country and could be made worse by the negative spiral in Venezuela, which has ironically not responded to the revival of oil prices that has dramatically improved Colombia’s external balance since early 2016.

Chart: Global Risk Index – still on the defensive even with pockets of eerie complacency

The risk appetite picture from our single global risk indicator remains unsupportive of exposure to risky assets and has dipped from the prior week’s reading. But the conflicting message from the various sub-components that comprise the indicator is the most interesting feature this time around. The “eerie complacency” in our headline is rather extreme quiet in FX, and especially US equity market volatility with the latter having virtually flat-lined since an important resistance line was broken on the S&P 500 chart.

FX volatility has only picked up slightly despite this week’s sudden dose of JPY volatility. Given current levels and the other components of our model flashing more notable signs of worry, we suspect that rising market volatility is a prominent risk in the weeks ahead.

Elsewhere, we note that junk bond spreads and credit indicators are stretching toward the worst levels for the cycle and emerging market credit spreads have not improved notably from their worst levels of late. Another indicator we are watching is the MSCI Emerging Market index, which is trading – in USD terms – below the 200-day moving average and right near recent lows and the lowest level of 2018.

EM Currency Outlook: US yields at key inflection point, but risk appetite focus could steal the show

Lately our focus on the downside risks for EM assets have been centered on the US dollar and rising US bond yields. This time around, we have a new twist on the situation, as the pressures from US yields have eased but other measures of risk have picked up notably as noted above in our discussion of the Global Risk indicator.

As well, there are prominent signs of flows leaving emerging market assets even before we have seen the latest versions of the most widely followed flow indicators, led by a pullout from Turkish bonds and equities (flows are mostly a coincident indicator, so the tough part is finding something predictive).

Some of the recent JPY strength – itself a risk-off indicator – may be down to an emerging market exodus.

Finally, regarding the commodity exporter theme we highlight above in the chart showing outperformance of commodity-linked FX, we would suggest that the oil market is possibly at a key inflection point now that Brent crude has traded at 80 dollars and is on its way back down in the second half of this week after Opec plus Russia have circulated the idea of increasing production to offset the drop in Venezuelan production of late. We have already been convinced that the global economy is facing a slowdown by later this year and the higher oil prices have underlined this risk.

Our strategy for allocating (long-only) exposure to emerging market is to start accumulating slowly during signs of an all-out rout in markets, where the washout provides a steeper discount in the highest quality EMs. Further along, we would look to add exposure more aggressively, also to the riskiest EMs once any major sell-off is behind us and the market is clearly on the mend. At present, we continue to sit on our hands.

EM currency performance: recent and longer term, carry-adjusted

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

The shortest term performance in EM currencies has turned flat to positive in most cases as the USD rally has eased – note the strong outperformance over the last week for the commodity exporting currencies relative to other EM peers.

Chart: three- and 12-month carry-adjusted EM FX returns versus USD

The longer term picture shows the Turkish lira firmly at the bottom of the class, but the chief contrast here is between the three- and 12-month performance in most cases as the EM relative weakness began almost four months ago when our Global Risk Indicator turned negative in early February.