EM FX rout could turn into a bloodbath

By:
Peter Garnham
Published on:

The stress witnessed in local bond markets during the past few weeks has driven emerging market currencies sharply lower, but the sell-off might only just be starting.

The next big risk to fear is the capitulation of real-money investors, who could pull funds from local bond markets en masse, according to Benoit Anne, head of EM strategy at Société Générale.

“This is a serious risk for previously popular investment destinations such as Turkey, Hungary, Russia or Mexico,” he says.

Anne says the latest data on foreign investor participation in EM bond markets continue to point to relatively heavy positioning on the part of international investors.

“This raises a significant red flag,” he says. “We are now bearish outright on most EM currencies, and no longer recommend exposure to EM bond markets.”

The violence of the move in EM FX markets has seen a truce called in the global currency war, with EM central banks, particularly in Latin America, stepping into the market to support their currency rather than contain appreciation pressure.

The main catalyst for the capitulation in EM FX has been the rally in global bond yields triggered by speculation that the Federal Reserve is starting to consider scaling back its massive quantitative easing programme.

John Normand, global head of FX strategy at JPMorgan, says even though the global bond market rout witnessed in May was only the third worst since the post-Lehman era, it was the most disruptive, judged by the rise in equity, rate and FX volatility, and contagion to emerging markets.

He says rises of 50 basis points in 10-year US Treasury yields – they have risen 45bp since May 1 – occur fairly regularly, but, as the chart below shows, contagion to EM local markets on the current scale is a rarer event. 

 Brutal sell-offs in treasuries and EM local currency debt
 

“This month’s vol moves are unusual too, highlighting how much more disorderly the rate sell-off has become,” says Normand.

“For the first time in four years, a US rate move is pushing equity and EM FX volatility higher, and while US rate vol has always risen during Treasury sell-offs, the magnitude of this month’s rally is the second strongest of the past six episodes.”

Rising volatility in Japanese rates is not helping either. The Bank of Japan’s contradictory promises at the start of April to buy massive amounts of JGBs to push yields lower and to achieve 2% inflation in two years, has resulted in JGBs becoming almost as volatile as US treasuries for the first time in a decade.

That is a development that undermines high-yielding EM currencies, given that Japanese investors are unlikely to increase their foreign asset purchases when their domestic markets are becoming higher-yielding as well as unruly.

Still, as can be seen in the chart below, it has been the prospect of the Fed tapering its asset purchase programme, rather than developments in Japan, that has had the most bruising effect on EM currencies.

The South African rand is down more than 10% since the speculation over the Fed scaling back its asset purchases intensified at the start of May, while Latin American currencies have also suffered sharp losses.

Asian currencies have been more resilient, but in EMs only the renminbi, Czech koruna and Hungarian forint have outperformed the dollar. That reflects position adjustment that has seen the return of correlation in the FX market, with funding currencies such as the forint and koruna benefiting as investors unwind positions. 

EM FX performance since April 4 and May10 
 

The potential normalization of US rates, even if it is orderly, threatens to weaken portfolio flows into EM, which in turn could prompt further weakness in EM FX on top of the recent violent price action.

In that contest, it is worth noting that Malaysia and South Korea benefited from the largest increase in portfolio flows in the last six years, some of that coming from real-money investors such as central banks and sovereign wealth funds.

Meanwhile, among currencies that attract the most speculative interest in EM, the South African rand and the Mexican peso saw increases in foreign holdings of public sector debt worth 6% of GDP as at the end of 2012 when compared to the average between 2007 and 2012.

JPMorgan has added the balance-of-payments financing gap to the, admittedly extreme, scenario that foreign investors cut back their holdings of EM public sector debt to the average levels that prevailed between 2007 and 2011.

As the chart below shows, the bank found that the South African rand, with a potential financing gap of 12%, was the most vulnerable currency to a reversal of foreign bond holdings, and the rouble the least. Across EM, the financing gap would range from between -4% of GDP to -12%.

“Positioning aside, we are wary of widening current account deficits in commodity countries amid growth deceleration,” says Bert Gochet, strategist at JPMorgan. “For those countries with headline inflation below targets – such as Chile, Colombia and Peru – currency weakness should be used as the main buffer for the adjustment to lower terms of trade.”