FX Watch – EM FX to weaken

by: Georgette Boele

In this publication: EM currencies tend to move in tandem with commodity prices but since May 2016 there has been a divergence. Going forward we expect EM FX to weaken with the exception of MXN and TRY, where we expect some recovery after the strong fall.

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EM currencies tend to move in tandem with commodity prices…

Emerging market currencies and commodity prices have a tendency to move in tandem as the graph below on the left shows. This is because they both tend to rally in an environment of:

–       positive investor sentiment,

–       a more positive outlook on the global economy

–       a more positive outlook on global trade

–       and when the US dollar is under pressure.

Moreover, higher commodity prices work their way through the economy of commodity exporting countries.

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In contrast, they tend to fall substantially when the US dollar rallies sharply and when investor sentiment and expectations about the global economy are characterised by doom and gloom. At the start of 2016, both rallied in tandem. The end of 2015 and the start of 2016 was characterised by a substantial wash-out of speculative positions in commodities such as oil, gold, copper and silver. This happened in a period of a somewhat weaker US dollar which supported both commodity prices and EM FX.

…but since 2016 there have been divergences

But since May 2016, EM FX performances have started to diverge most notably since the outcome of the US presidential elections. What has happened to explain this divergence? The Fed has hiked interest rates and 10y US Treasury yields have risen substantially.  Moreover, commodity prices have moved up in line with supply & demand balances and expectations about the global economy. Meanwhile, EM FX in general has moved in the opposite direction to the US dollar. However, this masks the strong divergence among EM FX as well which is somewhat unusual.

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Commodity exporting currencies have outperformed…

On the one hand, currencies of commodity–exporting countries have continued to perform well. For example the Brazilian real, Russian ruble, Chilean peso and South African rand have behaved mostly in a cyclical way meaning that they tend to have a positive relationship with local stocks and commodity prices but a negative relationship with equity volatility. In short, if investor sentiment and commodity prices are positive they perform well as we have seen recently.

…but trade sensitive currencies have underperformed

On the other hand, trade-sensitive currencies such as the Singapore dollar, Polish zloty, Czech koruna and Hungarian forint currently have an unusually positive relationship with equity volatility which is often combined with a negative relationship with stocks. This is a sharp divergence from the usual pattern of rising with local stocks and declining with volatility in stocks. This means that if investor sentiment deteriorates these currencies rise in the current environment. This is very surprising. It is likely that the prospect of more protectionism is weighing on the outlook for global trade and thereby also providing a negative backdrop for these trade-sensitive currencies.

There is more. The Turkish lira and the Mexican peso are currently behaving as a non-commodity trade-sensitive EM FX as well. For the Mexican peso this makes sense. Mexico may be an oil-exporter but in fact it is the factory of the US and mainly exports manufacturing goods. Because of this, the peso should behave as merely a trade-sensitive currency and not a commodity currency. Investors have dumped the peso because of President Trump’s rhetoric on NAFTA and building a wall between Mexico and the US. Both would have a negative impact on trade with the US.

The Turkish lira is a story on its own and it is not driven by the commodity price outlook. Turkey has weak macro-economic fundamentals, high dependency on capital inflows, political uncertainty, concerns about the independence of the central bank and non-transparent monetary policy. This is in an environment in which US Treasury yields will probably rise, the Fed will continue its normalisation process and the US dollar is relatively strong. In short, investors have given up on the lira.

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Going forward we expect weakness in EM FX…

Going forward we expect the performance of EM currencies to align internally as well to move in tandem with commodity prices again. Despite our optimistic outlook on the global economy we think that the upside in commodity prices is rather limited. Higher energy prices and base metal prices will probably trigger a response on the supply side resulting in more supply coming to the market. Moreover, we expect the Fed to hike rates more than financial markets currently anticipate. In addition, we expect US Treasury yields to rise. This should result in a rise in the US dollar and weigh on commodity prices and EM FX.  In addition, the investors will probably start to focus on the structural imbalances and political uncertainty again in the various emerging markets. This will probably also weigh on EM FX. Therefore, we expect EM FX to weaken versus the US dollar this year.

…but there are some exceptions

However, there are some exceptions. We think that the Turkish lira and Mexican peso have been beaten up too much. From a valuation point of view they are very cheap. The Purchasing Power Parity (OECD) for USD/MXN is 12.39 and for USD/TRY is 2.54. At some point in time, all the long positions will be squeezed. Moreover, it will be too expensive or difficult to go short in the peso and the lira. In this the central bank will play a crucial role. The Banxico has already increased official rates at a higher pace than the Fed and intervened in currency markets. If Trump’s actions are somewhat softer than his rhetoric (which we expect), there is room for a recovery in the value of the peso. The case for the Turkish lira is far more difficult because of its weak fundamentals and Turkey’s messy political situation. Also here at some point in time everyone who wants to be out will be out and if the central bank takes measures against capital outflows and/or makes shorting the lira very expensive, the lira will start to stabilise and a recovery will be possible.

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