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Macro Outlook: The US rate cut cycle has begun
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Chief Investment Strategist
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EM FX Carry Trade Update October 31, 2019
John J. Hardy
Chief Macro Strategist
Summary: We may have seen at least a temporary peak in conditions that are supportive of EM carry trades over the last week as complacency reached remarkable levels rarely recorded by our Global Risk indicator. The most interesting test for recent EM strength and conviction that the US Fed will remain on top of the situation would be a weak couple of months US economic data.
A number of recent developments have supported EM trades, including large-scale new easing from the Fed, both in terms of the three rate cuts administered since the summer and the fresh expansion of the Fed’s balance sheet to the tune of $60 billion per month in T-bills on top of the large repo operations aimed at countering liquidity problems in the US banking system, at least in part driven in turn by the US . And no doubt about it, a weak US dollar is normally associated with heavy gains in EM currencies and assets. But we struggle with a bit of cognitive dissonance here if the US economy is indeed heading toward a recession, which would require more Fed easing. Up to this point, the market has largely celebrated the easier Fed, but at some point, a slowing economy is normally associated with widening credit spreads and safe-haven seeking, conditions not normally associated with positive EM asset/currency performance.
Chart: Saxo Bank Global Risk Indicator
Our global risk indicator recently peaked out at its highest reading since the remarkable conditions that prevailed for much of 2017 in which everything risk-correlated, particularly EM, did very well. This time around we have a hard time believing that similar conditions can endure on our suspicion that the US is heading for at least a minor recession, which is normally associated with weaker financial conditions, widening credit spreads, etc., basically all of the things that normally provide headwinds for EM assets and currencies.
An added wrinkle is the prospect of a US-Trade deal. Yes, US President Trump, as he eyes his 2020 re-election campaign, is likely very willing to walk back some of the US tariffs and make a narrow, transactional deal based on Chinese promises for large-scale agricultural and other purchases, but we see will be no profound, deeper deal between the two rivals, and a recent Bloomberg article even suggested that even the narrow deal could be endangered. Stay tuned for that and stay tuned for how the market treats US incoming data, especially of the weak variety.
Carry Trade Short Term Performance
The shorter-term performance of EM currencies remains generally very positive over the last month, but the last week has seen a smaller contribution as risk conditions suffered a bit of a stumble after the FOMC meeting. BRL was the star performer over the last week as it has accomplished a major pension reform deal that will markedly improve the budget sustainability. ZAR and CLP are sharply lower on idiosyncratic reasons – ZAR we discuss below and CLP due to disruptive protests and the risk that the country will have to widen deficit spending to respond to public demands. With a policy rate below that of the US, holding CLP offers nothing in the way of carry rewards for traders unless it is held versus an even lower yielding funding currency.
A snapshot of specific EM credit spreads
The chart below shows a snapshot of the credit spreads for four EM currencies’ USD bond and their US counterparts over time and relative to the USD exchange rate. Most EM currencies have seen tightening credit spreads as financial conditions have been very favourable – supporting the recent strength in EM. But South Africa’s credit spreads have taken a sharp turn for the worse here after it recent published its latest budget, which will include very large costs linked to shoring up troubled power provider Eskom, a move that has prompted fears that South Africa’s debt could be downgraded and triggering a sharply weaker rand this week.
Carry trade performance*
Among the funding currencies, the JPY has been the best behaver in remaining weak against the broad market – at least until its strengthening move in the wake of the FOMC meeting. Sterling has been a funding currency to avoid as hopes that a path to a soft Brexit remain on track and No Deal is unlikely have fed a considerable rally - though it could be faced with a flat period from here as we await for the December 12 election result.
Among the EM currencies, most have turned the corner over the last month from prior weak performance, including BRL noted above. We are writing this report with USDCLP at a new 15-year high.
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. Note the further collapse in carry available for TRY longs after the recent massive 250 basis point rate cut and more likely on the way, provided TRY is stable. Brazil cut its policy rate this week by another 50 basis points from the old record low to a new one of 5.00%.
* 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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