Resist EM risk-on, FX dealers warn

By:
Joti Mangat
Published on:

A sharp spike in US equity markets – with the Dow, S&P500 and Nasdaq jumping by more than 2% on news that US lawmakers might agree to extend the debt-ceiling deadline by six weeks with no fiscal conditions – drove Asian equity markets and key emerging market currencies higher against the dollar, albeit in narrow ranges amid thin trading, according to currency managers.

The risk-on move saw the Brazilian real increase 1.43% against the dollar, while the Turkish lira posted similarly strong gains of 1.38%. Meanwhile in Asia, the emerging markets’ worst-performing currencies since the summer, the Indian rupee and the Indonesian rupiah, staged substantial reversals with INRUSD gaining 0.62% on the week.

Support for the Brazilian real extended beyond the US political sphere, however, as the Banco Central do Brasil (BCB) hiked interest rates by 50 basis points to 9.5% and left the door open to a further 50bp hike at its next meeting in November.

“It’s all about the BCB’s communication now,” FX strategists at Brown Brothers Harriman state in a report. “We assume that the curve will flatten and a 50bp hike will soon be priced in for the November meeting, though this also means that the risk will shift towards a disappointment.”

Similarly in India, a rapidly narrowing external deficit and a more credible central bank lent support to the rupiah as September’s trade deficit number narrowed to $6.7 billion, the lowest since March 2011.

The narrowing was caused primarily by collapsing imports, which fell by 18% year-on-year, the largest decline since 2009, led by gold imports, which have plummeted by 82% year-on-year after government measures to contain them. Exports, meanwhile, rose 11.2% in September.

“Based on this reading, we estimate that the current-account deficit during the July-to-September quarter probably narrowed to 2.9% of GDP compared with 4.9% previously,” says economist Sanjay Mathur, head of economic research Asia Pacific ex-Japan with RBS.

However, with uncertainty around US economic fundamentals and the likely trajectory of Federal Reserve tapering, traders remain cautious over the extent of the market moves, with the immediate risks skewed to dollar strength.

“Emerging market FX responded very strongly to the news of a short-term fix on the debt ceiling, but as these came amid very light volumes, the extent of the moves is somewhat suspect and caution is advised,” says Robert Savage, chief strategist with New York-based currency hedge fund FX Concepts.

Once the US government returns for business, better clarity on the state of the US economy and probable Fed policy will likely see EM FX resume its recent weakening trend.

“If US politics can return to a semi-normal state, and Janet Yellen gets congressional approval faster than expected, the Fed may feel comfortable enough to start tapering in December,” says Savage. “That’s essentially the risk for owning EM FX, stocks and bonds right now.”

Dealers advised profit taking, rather than deepening of long positions in EM FX, with the expectation that risk-on will quickly become risk-off as the prospect of higher rates returns to the agenda.

“We advise that clients maintain an on-hold strategy on EM currencies as we are concerned that the current tentative risk environment morphs into a more traditional risk-off period, which will impact the EMFX universe,” currency analysts at Morgan Stanley in New York said last week.

Indeed, early signs of this emerged last week with global equity markets coming under pressure.

With the near-term tapering risks in the balance, strong EM FX valuations could instead present an attractive opportunity to hedge against a sudden move lower in expectation of an improvement in the US political situation.

“We do not see attractive risk/reward in positioning for EM currency strength, and would instead consider ways to hedge against potential market weakness, and we see good value in cheap tail-risk hedges such as one million USD/HUF, USD/KRW, USD/TRY and USD/ZAR calls,” stated Morgan Stanley.