The bank says in 2012, the increasing likelihood of a recession in the eurozone, below-consensus growth in China, as well as political risks in both the developed and the emerging world will strengthen the case for EM policymakers to cap strength in their currencies. Importantly, with the main deterrent for currency intervention – EM inflation– in decline, central banks that have already suppressed local currency appreciation throughout 2011 will have an even stronger case for ramping up currency intervention efforts in response to weakening global demand for their exports.
Furthermore, the sterilisation costs associated with FX intervention in EM have hardly risen despite monetary easing in the G3. This is because EM has also seen a notable shift lower in yields.
In addition to further intervention from Asian central banks –the usual suspects to engage in currency intervention – UBS economists expect central banks from the likes of Turkey, Brazil, Indonesia, Israel and Romania to take measures to weaken their currencies in response to external risks to growth.
Although strong fundamentals in emerging markets in the form of relatively resilient growth, easing inflation and continued balance sheet strength seem consistent with an appreciation of EM local currencies, the offsetting effect of an intensification of ‘currency wars’ will be a key aspect to consider when trading EM FX.
Bhanu Baweja, global head of EM fixed income and FX research at UBS says he expects there will be opportunities for gains in some regions for EMFX, but investors should carefully select the correct EM currencies.
“There are a few places in Asia such as Indonesia and Singapore where there are idiosyncratic positives and we expect these currencies to outperform”, says Baweja.
CEE on the other hand, will remain unattractive, due to the large economic exposure to the eurozone as well as European banks continuing to deleverage in the region.
In addition to looking for the correct currencies in which to establish long positions, selecting the appropriate G3 currency to short will be equally important consideration, with the euro the best candidate.
“You’re going to make the bulk of your return on the DM leg, rather than the EM leg so it’s important to consider what you are going to short”, says Baweja.
A key theme will be that the dollar above all, will likely strengthen going into 2012. As balance sheet expansion by the Federal Reserve looks unlikely and sovereign risks in the eurozone deepen so will the market’s demand for dollars.
“We expect EMFX will be flat or slightly down against the dollar in the coming year and so if you want to be long in EM FX, the euro will be a better funding currency.”