Correlation breakdown bodes well for EM currency investors
There has been a welcome change for currency investors since the start of the year as the correlations between emerging market (EM) currencies have dropped to levels last seen before the eruption of the financial crisis.
Correlation among EM currencies, which touched record high levels in 2012, has decreased drastically in the past few months and now stands at its lowest level since September 2008, just ahead of the collapse of Lehman Brothers. Between 2009 and the end of last year, alternating periods of risk-on and risk-off (RORO) trading relating to the subprime crisis and then the eurozone debt crisis – and global authorities’ attempts to solve those problems – provided a global market-moving force common to all EM currencies.
However, as global market conditions have normalized in the past few months, with fears over the collapse of the euro receding and hopes for global growth increasing, country-specific factors have grown in importance among EM currencies, pushing correlations lower.
There is, in other words, no longer one single EM currency trade but rather a series of individual decisions that have to made based on domestic monetary conditions and expectations of future policy.
That stands in contrast to the developed world, where ultra-low interest rate setting has destroyed the mechanism that links monetary policy to currency movements, leaving the dollar, euro, yen and sterling still in thrall to market sentiment.
“One of the most interesting things that has happened since the end of last year has been the remarkable rise of intra-EM diversification,” says Javier Corominas, head of economic research and strategy at Record Currency Management. “There is differentiation now in terms of interest rate cycles.
“Investors are much more discerning and discriminating regarding EM currencies. If that continues, it means there is not an EM FX trade – there are different stories within EM.”
An example is the CE3 currencies – the Polish zloty, the Hungarian forint and the Czech koruna – which, up until the past few months, have traded in sympathy with each other for most of the current decade.
Now, they are trading to different beats, with the long-term outlook for the zloty supported by relatively strong economic fundamentals and the prospect of the end of the National Bank of Poland’s interest rate cutting cycle.
In contrast, weak fundamentals in the Czech Republic have seen the exhaustion of interest rates as a monetary policy tool, with investors wary of currency intervention. In Hungary, more interest rate cuts are expected as the authorities attempt to revive an economy that went into recession last year.
“Hungary is now seen differently to Poland, which in turn is different to the Czech Republic,” says Corominas.
“That is something we monitor closely as we are trying to diversify our portfolios. Now we are happier holding an overweight position in CE3 currencies, because we know we are going to get some diversification within that region.”
That story continues across the EM world.
In Latin America, the diverging performances of the Brazilian real and the Mexican peso have been stark during the past six months.
The real has lagged as the Brazilian authorities have signalled a desire to keep the USDBRL exchange near R$2.00 in a bid to keep a happy medium between protecting its exporters and containing inflation, intervening in the futures market to suppress the value of the currency.
The Mexican peso, in contrast, has been the darling of the currency markets, appreciating in part as a reflection of government attempts at fiscal and energy reform, which some believe could lead to potential rating upgrades later in the year.
Across Asia, currencies are also trading according to their own idiosyncrasies, with, for example, the Korean won under pressure amid escalating military tensions, and uncertainty surrounding the forthcoming elections pushing up volatility in the Malaysian ringgit.
Of course, one reason to be cautious on EM currencies in the medium term, and which has the potential to see correlations rise, is increased speculation about exit strategies in the developed world. Such speculation has the ability to heighten risk aversion generally and hurt EM currencies across the board.
The Federal Reserve is the natural candidate when considering which of the world’s large central banks will exit first from their ultra-loose monetary stance, not least because it is the US that is seen as the economy with the ability to bounce back more strongly in coming years.
A growth-led rise in the dollar should also see pressure on commodity-linked currencies, with the Brazilian real, Chilean peso and South African rand likely to come under pressure along with their counterparts in the developed world, such as the Australian and Canadian dollars.
Still, for now, labour market data in the US are not signalling that the country’s economic recovery is self-sustainable, therefore more quantitative easing from the Fed is in the pipeline.
Only when the US economy shows sustained signs of recovery is the Fed likely to cut back its asset purchases and prompt a rise in long-dated US yields that will support the dollar.
With that day still some way off, currency investors can continue to enjoy the benefits of diversification in the EM world.