EM FX Weekly: China intervenes to slow the CNY slide

BRL:  the Brazilian real stands out for its relative weakness. Weighing on the currency, besides the ongoing political dysfunction we have noted in previous weeks, are ugly price developments for a number of Brazil’s major exports, including coffee and sugar, both of which are currently trading near 10-year lows. Iron ore prices are also weak and Brazil is particularly vulnerable in any trade war scenario that weakens China’s economy as China is far and away its largest export destination (around 19% of exports in 2016). The one positive note would be that China’s tariffs on US soybeans could boost prices for Brazil’s soybeans – exports of which were more than 10% of Brazil’s total exports in 2016.

MXN: topping the EM performance charts this week has been the peso, as the market has decided that incoming president Obrador is no immediate threat to the currency and the young administration has sent market friendly signals, like promising not to roll back prior reforms allowing foreign investment in Mexico’s energy sector. Still, policy moves from Obrador will bear close watching for MXN traders as his coalition controls both houses of Mexico’s Congress and once all votes have been tallied (not yet there as of this writing), could see Obrador controlling a two-thirds majority that allows for constitutional reforms. This is a powerful presidency – ad hoc policy headlines risk making a large impact – with the risk skewed a bit more negative rather than positive at the moment, given the peso’s solid recent bounce off of lows. 

CLP: the Chilean peso has been weighed down by the ugly decline in copper prices, which have slipped far below the pivotal three dollars/lb. level, trading near $2.80 as of this writing. Given that copper is far and away Chile’s most important export, this presents further danger of a decline in the peso’s fortunes. And, as we have noted that Chile’s external debt position has worsened materially in recent years, the credit spreads versus DM debt look complacently tight. Stay tuned – still lower copper prices could drive further CLP declines.

Chart: Global Risk Index – risk conditions worsen further

Our broad Global Risk indicator eased away from its worst levels, as the recent worsening of the broad EM credit spreads has yielded to a more sideways tendency, our corporate credit measures were mixed, and volatility measures pulled back lower after a recent modest bounce. The market is likely very happy to see China’s intervention after a rather scary sharp weakening in the renminbi. Still, we’re reluctant to believe that the market is set to launch into a major risk-on move from here. Friday of this week, July 6, marked the beginning of the actual trade showdown between the US and China with the first $34 billion in mutual tariffs. And US President Trump is out on the campaign trail and finding receptive crowds as he continues to rail against China on trade.  On his way to a recent campaign event in Montana, according to CBS news, Trump said on the subject of tariffs that “We have $34 billion tonight, then another $16 billion in two weeks,” “And then as you know we have $200 billion in abeyance, and then after that $200 billion, we have $300 billion in abeyance.” As if that wasn’t enough, he added “It’s only China,”.

EM Currency Outlook: CNY and US data in the spotlight next week

There is something disquieting rather than encouraging about the market’s current complacency this week despite the backdrop of developments – particularly the ongoing threat of deepening trade tensions as US and Chinese trade tariffs went into effect this Friday. But any rally may be of a modest scale and only a result of a lack of fresh bad news rather than new positive developments during the slowest of the summer months of July and August. With Trump on the campaign trail, we can count on inflammatory rhetoric on trade regardless of the market’s reaction function. 

Besides inflammatory trade talk and the risk it brings to global risk appetite, the other two chief risks are from the CNY and from the US dollar. As of this writing, we haven’t had a look at the June US jobs and earnings numbers, but the very strong ISM surveys and FOMC minutes this week failed to shift Fed expectations even a notch higher and the US dollar is on its back foot locally.

The FOMC minutes released this week did more prominently mention the risks from tariffs and a flattening US yield curve even as they noted a very strong economy. But given the very strong activity and inflation numbers in the US (next week’s June US CPI expected to see the core matching the post-GFC high of 2.3% YoY), it looks more than a bit complacent to us that the market has not priced even 50/50 odds of the Fed moving twice more this year (in other words that the Fed is seen more likely to only hike once more this year). The next important Fed-related event risk is the July 17-18 semi-annual testimony by Fed chairman Powell before congressional committees. This event should provide a sense of the degree to which trade tensions are unsettling the Fed leadership or raising the potential for the Fed to back off from its forecast trajectory of rate hikes. We think Powell prefers to look at the actual data in front of him, which points to higher US rates rather than lower ones – a decided headwind for Emerging Market assets.

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

Chart: the weekly spot and 1-month carry-adjusted EM FX returns vs. USD.  The Mexican peso more than sticks out on the positive side in our recent performance table with impressive gains over the Mexican election. The peso is often considered an EM bellwether, though that’s not the case this time around as the currency is very much doing its own thing. And most emerging market currencies saw little change or more negative tendencies over the last week.

Chart: 3-month and 12-month carry-adjusted EM FX returns vs. USD
 
Commodities exporters are prominent among the currencies at the bottom of the 3-month rankings in our EM universe and the Brazilian real is somewhat unusual in that its aggregate weakness over the past year has been concentrated over the past three months as the market has wakened to its structural weaknesses and the political uncertainty. At the top of the performance chart are the two currencies in our universe running a managed rate versus the US dollar (HKD and PEN) hardly impressive. It will be interesting whether Peru will persist with its stable, managed level if copper and gold prices continue to weaken and the USD is stronger as copper looms large in Peru’s export mix, if not as as large as for Chile. From late 2014 to early 2016, USDPEN devalued from about 2.80 to over 3.50 before settling into a 3.20-3.30 range since early 2017.