FX Update: EM focus: running out of steam?

FX Update: EM focus: running out of steam? by Michael McKenna
Given the weak US dollar of late, EM currencies have naturally benefitted a great deal over the last month. The pace of gains has moderated over the last week or more ahead of the important FOMC meeting this Wednesday. The FX Update for today focuses on EM currency performance and perspectives for the New Year.

EM performance – recently and over the past year
The US dollar and global risk appetite are usually the two most important factors for EM currency performance broadly, and often dollar direction and risk appetite are strongly negatively correlated and somewhat the same thing. Still, there are inevitably many moving parts and idiosyncratic stories driving relative individual EM currency performance, even if the majority of EM currencies swim in the same direction over medium-term and longer time frames.

Chart: Short-term EM currency performance
In the short term performance charts, we note that the Chinese yuan and Asian EM currencies most firmly in its orbit (KRW, TWD, MYR, THB) have seen their performance cool notably over the last week or more, while still up over the last the one-month against a struggling US dollar. Note that USDCNY and UDSKRW have an r-squared of over 0.92 for the last 200 trading days and, meaning that the Korean Won is more or less thoroughly in the CNY’s orbit – which makes sense given the country has a nearly 11% weighting in the official CNY reference basket – fully half of that for the US dollar for an economy a fraction of the size (and a currency with orders of magnitude less liquidity). The strongest performers over the last month are those currencies mostly firmly linked to the hopeful narrative for 2021, that a post-Covid-19 vaccine recovery on its way and will see a sizable rebound  in demand, with still generous monetary policies possibly driving inflation, particularly in the  commodities sector. Note that all of the four strongest performers over the last month are closely linked with specific commodities, or baskets of commodities in Brazil’s case (soybeans, coffee and iron ore). On the weak side, the Turkish lira is a victim of the time window of 1-month, as the currency topped out in mid-November after a huge surge from the October lows before Erdogan announced he would take the “bitter” medicine needed of strong rate hikes to slow the rapid devaluation of the currency.

Chart: Longer-term EM currency performance
This chart shows where the longer-term underperformers simply can’t hide. Brazil has been the 12-month worst performer as it struggled with the Covid-19 pandemic and the collapse in prices for its important commodities this spring like oil and iron ore, not to mention the slashing of its Selic policy rate by some 250 basis points this year. As note above, however, it has surged strongly over the last month or more. Still rather surprising that its carry-inclusive downside exceeded that of the very weak Turkish lira. The majority have strengthened versus the US dollar over the last 12 months.

Chart: Global Risk Indicator
Our Global Risk Indicator is still strongly in the green but has faded somewhat, in part on a pickup in volatility measures and as credit spreads have largely stopped falling (though not yet rising anywhere by any meaningful amount). Timing-wise, if the FOMC meeting this week – more below on that – fails to support a further sell-off in the US dollar for a while, the market may be a bit out over its skis and due for a correction in coming weeks, though if a reflationary recovery is what we get in 2021, and one with a weaker USD (which is really a necessary pre-condition for a reflationary outlook anyway), then EM currencies should put in a strong 2021.

Watching the FOMC and end-of-year.
The FOMC meeting this week could prove a non-event or one that moves the US dollar sharply in either direction. If the Fed entirely fails to deliver anything at the meeting, this could be seen as hawkish and as a sign that the Fed is a bit concerned that it may have over-eased financial conditions and that this could bring instability in financial markets, preferring instead to hammer on the message that it has done its part with monetary policy to keep markets orderly and rates low, now it is time for fiscal policy to take over. If this is the Fed’s stance, I suspect the message would be delivered extremely gently and clouded in weak language.

If, on the other hand, the Fed indicates that its level of concern has picked up notably on some of the recent weakness in employment-related numbers, it could signal that it may shift its mix of purchases toward the longer maturity treasuries after yields have backed up a bit at the longer end of the US yield curve. Some measure of this seem to be the consensus expectation. A hybrid of these two is also possible – or a signaling that a future policy of shifting purchases will be implemented if long rates spike too quickly and the jobs data continue to bog down. We’re not sure how reactive the market is to all of this, but given the rather aggressive USD move in places, the FOMC meeting will need to bring material signals that the Fed will provide more easing or the USD could risk backing up for a time. And EM will always prefer an easy Fed and react poorly to any shade of a “hawkish” surprise. On a different note, end-of-year factors could be in play for the final couple of weeks of this year that bring unpredictable and unattributable swings in markets.