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John J Hardy
Saxo Bank’s head of FX strategy John Hardy takes a closer look at trends and moves in today’s forex charts, including EURUSD, USDJPY, AUDUSD, and EURSEK.
Article / 12 March 2018 at 16:13 GMT

EM FX Weekly: Return to '2017 normal' likely to fade

Head of FX Strategy / Saxo Bank
Denmark
Bali, Indonesia
Why are investors shying away from Indonesian assets? Photo: Shutterstock

By John Hardy
 
The last week has seen the market trying to revive the Goldilocks trade, the idea that the global upswing is continuing, but that inflation remains so elusive that central banks will feel comfortable sitting on their hands rather than overreacting. We suspect the shelf-life for this attempted return to “2017 normal” will quickly run out of steam.

The weekly wrap: EM performance mixed at best as global risk appetite bounces back

Last week emerging market currencies were very mixed despite a rather supportive backdrop in risk appetite and ongoing improvement in global risk measures (see below). It is tough to draw any single conclusion linking EM performance to the broader macro environment, but a fairly resilient performance from the US dollar and a lack of enthusiasm for a global reflation trade perhaps acted as a brake on EM performance. 

More supportive was the watering down of Trump’s tariff measures, though these still were signed into law and some EM countries will fail to escape them. In addition to improved risk appetite, another dampener on volatility potential was the CNY, which remains dead in the water recently even as (or more likely because) China’s political elite is rearranging itself in dramatic fashion as Xi Jinping is anointed chairman-for-life.

Friday’s US jobs report has encouraged an attempt to put back on the “Goldilocks” trade – a risk-on stance on the notion that central bank policy tightening will remain so slow due to low inflation that we needn’t fear their taking away the punchbowl anytime soon. 

The central data point encouraging this notion was Friday’s February US average hourly earnings, which came in below expectations at 2.6% year-on-year and saw a downward revision of January’s large spike. That latter spike was given considerable credit in triggering the volatility event in equity markets that marked the beginning of February and saw waves of risk aversion propagating weakly through other risk assets, including emerging markets. 

Also encouraging risk appetite were a combative Mario Draghi at the European Central Bank press conference last Thursday and the Bank of Japan insisting that only the return of inflation will bring a shift in policy.

Chart: Global Risk Index – close to getting back to neutral

The chart below is a Global Risk indicator which offers a perspective on the short-term level of risk appetite relative to the longer-term backdrop. The worsening risk conditions we noted last week have quickly yielded to a more benign environment, a development that started almost at the minute we published las week’s update. Again, adding to relief were the lack of hawkish surprises from the ECB and BoJ and lower US average hourly earnings. 

The bounce-back in risk appetite is not necessarily thematically positive for EM if the global growth story doesn’t pick up further from here. We still have our concerns expressed above in the outlook that volatile markets are here to stay and that EM exposure is generally not attractive unless we see a larger washout in positioning.

Global risk
Source: Saxo Bank

EM currency outlook: What are we waiting for?

As noted above, the attempted return of the Goldilocks trade has done very little for EM currencies. We continue to see risks that EM currencies (in broad terms) are a bit richly valued. We are concerned that the global cyclical upswing may have peaked for the cycle, with China and the US most at risk of slowdown in the months ahead and a repricing of much of EM FX an ongoing risk. Complicating the picture for EM currencies if we are wrong is that if the US doesn’t begin to show signs of slowing until later this year after a possible boost from Trump’s tax reforms, then the market has not priced enough Fed hikes into the mix. 

Sounds like a bit of a lose-lose for EM unless we are wrong on where we are in the economic cycle.

On top of our overriding concern that Trump’s trade wars are only in their initial skirmish phase, we upgrade our concern on the fallout from Beijing’s future policy moves and we’re frustrated, as always, with the opacity of the decision making process in China. The most interesting development over the last couple of weeks in FX has been the challenge of the upper range of the USDHKD exchange rate with the HKMA’s currency board arrangement under siege as local low rates have declined relative to their US counterparts. Media reports the situation as if it is merely the pressure from the local rates versus US rates carry trade – but surely there is more afoot? After all, the USD should be rising even more so against other currencies from a carry-trade perspective. Is this rather some kind of leakage from China’s strict capital controls regime which keeps the Chinese currency overvalued? Stay tuned.

Another issue that has cropped up in recent weeks is the Libor-OIS spread, which has widened to some 44 basis points over the last several weeks to its widest level since the global financial crisis. This measures suggests tightening liquidity in US dollar and could be linked to the Fed’s QT (shrinking its balance sheet), the US treasury and its maneuverings as the debt ceiling issue has come and gone, and/or US corporations sending huge sums of money home from abroad and therefore draining the offshore USD market. 

This could be a very technically driven issue, but it bears watching if it becomes a focal point, as EM should be generally sensitive to USD funding.

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

Chart: the weekly spot and 1-month carry-adjusted EM FX returns versus USD

A rather dramatic contrast in many cases this week between the one-week and one-month performances in our universe. The worst performer in the one-month category is the Indonesian rupiah (IDR), our spotlight currency for this week. 

We note the general correlation in Asian EM FX performance over the last month and longer with current account dynamics, as those with large current account surpluses like South Korea (KRW), Thailand (THB), and Singapore (SGD) have outperformed countries with greater external vulnerabilities, like IDR and PHP. 

There could be linkages to the recent protectionist theme as bond portfolio managers look at their risks in EM. But in FX and economic terms, isn’t it possible that the big export-driven economies are most at risk if the threat of trade wars rises?

Carry-adjusted
Source: Saxo Bank

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

It is certainly rare to see the HKD sticking out on the 12-month performance category, but it is the weakest currency of the last 12 months in our universe of currencies. The broader EM performance in the three-month perspective will look increasingly weak in another couple of weeks if these currencies don’t strengthen further, as much of the three-month appreciation was due to the USD weakness from mid-December to late January. 

EM FX returns
Source: Saxo Bank

Spotlight currency this week: IDR (Indonesian Rupiah) weak despite supportive backdrop... is this a warning sign?

We noted above the general alignment of Asian EM FX with current account considerations over the last several months to a year, at least if we are to believe the developments in our small universe of Asian currencies. The centre of gravity in China is the renminbi, which has strengthened considerably over the last 12 months, taking other Asian FX currencies with it, like the Thai baht (THB) South Korean won (KRW) and Malaysian ringgit (MYR). 

Common among these latter countries is their solid to very large current account surpluses, from Malaysia’s modest 3% to Thailand’s ridiculous 10.8% surplus. The laggards among Asian FX are largely the economies with current account deficits, or in approximate current account balance, including the Philippines (nearly flat, but down from a 2% surplus in early 2016) and Indonesia, with a -1.7% deficit, improved from -3% in early 2016.

Chart: Indonesian rupiah versus Asian FX peers. 

Note the badly lagging performance of the IDR (bright blue line) since early 2017. The chart shows the spot exchange rate, but even with Indonesia’s higher carry, it has badly underperformed. The trajectory of KRW, THB and MYR are clearly following CNY’s (the black line) lead over this timeframe. 

IDR

















Source: Bloomberg

The weak performance for the Indonesian rupiah is somewhat remarkable, given the reasonably strong real yields and a slow dribble of positive news from bond rating agencies that should theoretically boost foreign appetite for Indonesian bonds, an important source of support for the currency due to the size of foreign ownership of Indonesian debt. 

Last May, the S&P ratings agency upgraded Indonesian long-term sovereign foreign currency debt and Fitch did the same in December, with a Japanese rating agency doing the same as recently as early February. Perhaps even more positive, Bloomberg announced in late February that Indonesian sovereign debt will be included in the Bloomberg Barclays Global Aggregate Index in May of this year.

We’re not sure what the driver is here, but the market does not like Indonesian assets relative to assets elsewhere, a bit of a warning sign for the currency. This could merely be a market that feels greater opportunities are available elsewhere – for example in South Africa, where there has been a dramatic recent shift in investor sentiment (see chart below). On the other hand, important local/regional elections are coming up in Indonesia in June, with the presidential election to follow in 2019, and investors may fear that the fiscal dynamics (budget deficit hovering around 2.5% the last three years) may continue to erode on populist measures aimed at the election cycle.

The current government’s structural reforms and other initiatives leading to the rating agencies upgrades of Indonesia’s creditworthiness are simply failing to impress at current levels, and Indonesia’s central bank isn’t doing much to help by building reserves to the tune of $10-12 billion since early 2017. That being said, the currency isn’t likely to suffer any sharp bout of depreciation unless global markets lurch into an ugly risk-off mode, with IDR perhaps most sensitive to such a development if the source of concern is China.

Chart: Indonesia-South Africa credit spread versus IDRZAR exchange rate

A very simple way to chart the relative development in sovereign credit ratings is via the sovereign CDS spread, in this case the spread between Indonesia and South Africa, and comparing that with the exchange rate. 

The dramatic reassessment of South Africa’s sovereign risk has been the main driver of the compression in the spread. In relative terms, the move may be overdone – but is that owing to excessive ZAR strength or IDR weakness or a bit of both? 

IDR does look a bit too singled out by investors relative to fundamentals. A comparison of specific US treasuries and individual Indonesian and South African USD denominated sovereign bonds expiring in 2025 argue the same credit spread story, as the South African-US spread compressed some 20 basis points, while the Indonesian one widened 17 bps since the last trading day of 2017.

IDRZAR
 

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