FX Monthly – Deconstructing EM jitters

by: Georgette Boele

Emerging market jitters have taken centre stage but currency weakness has been concentrated

Since the end of last year, emerging market currencies have once again come under pressure. However, the move differed from the sell-off last summer during the so-called tapering dry run, with the weakness relatively concentrated and driven by a number of domestic themes. Still, there have been more general fears of contagion in emerging markets that have also hit broader global financial market sentiment. There is no denying the risks. There has been a wave of capital inflows into emerging market assets over recent years and there is a possibility that these flows will reverse abruptly leading to plummeting currencies and asset prices and general financial market instability. Investors could simply get spooked by the few bad apples.

Broad EM fundamentals are positive and we expect stronger global growth

However, we think that EM fundamentals as a whole are healthy. They have a current account surplus on aggregate, external debt is low and currency reserves are three times higher than they were in the 1990s. Significant progress has also been made in macroeconomic management over the last twenty years, and in contrast to the 1990s, exchange rate regimes are now flexible. Overall, we think EM currencies will likely remain volatile, and given our bullish view on the US dollar, few will be able to resist the tide. Nevertheless, we do not expect a widespread long-lasting collapse in EM currencies consistent with another crisis. In fact, we continue to expect investor sentiment to improve in the light of stronger global growth.

We remain US dollar bullish and euro bearish

Therefore, we remain negative on safe haven currencies such as the Japanese yen and the Swiss franc. We continue to hold on to our bullish US dollar view mainly driven by our above consensus view on the US economy and our expectation of relatively early Fed rate hikes. We also continue to expect euro weakness versus the US dollar, British pound, Swedish krona and Polish zloty. These currencies offer more attractive economic growth rates and monetary policy is likely to diverge, with the ECB easing monetary policy further.

Changes to our high conviction views

We still expect falls in the Australian and Canadian dollars. However, we have removed them from our high conviction short list, because we believe the downside is now limited following the sell-off. We remain positive on the Chinese yuan. But we would like to express this more versus Asian currencies. Therefore we have taken short USD/CNY and long KRW/JPY off our conviction list and replaced them with a CNH/JPY long.