In this publication: Following our change in US dollar view, we adjust our EM FX forecasts upwards. Main risks are in commodity-linked FX, because of expected weakness in oil and some metal prices and substantial speculative long positioning. Trade-linked EM FX will probably be more resilient170302-EM-FX.pdf (346 KB)
Last week we changed our US dollar view and our forecasts for the dollar against the euro. Yesterday we also changed our Fed view; we move forward the rate hike we expected in June to March. We still expect three Fed rate hikes in 2017, but the risks of a fourth rate hike have risen. Although there could be some temporary waves of positive US dollar sentiment, we think that a strong US dollar rally is unlikely. In fact, we think that the dollar rally is behind us. This is because the real yield support is fading and politics is uncertain on both sides of the Atlantic. Most of the positive news – in terms of the US economy and upcoming Fed rate hikes – is already reflected in the price and investors are already positioned for dollar strength. What are the implications of the change in US dollar view and bringing forward the Fed rate hike for emerging market currencies? We will answer this question below.
We are now less negative on EM FX…
Following our change in US dollar view, we have adjusted our EM FX forecasts upwards. There are a number of factors that are positive for higher emerging market currencies. For a start, it is likely that the global economy and global trade will improve further, especially in countries which went through a severe recession. Moreover, we expect the domestic economic situation to improve in many EMs. This means that we foresee better economic growth rates, better growth/inflation trade-off (for example Brazil) or the economic situation being less negative than feared by investors (for example Turkey and Mexico). What is more, investor sentiment will probably remain constructive which is positive for emerging market currencies (strong negative relationship with equity volatility, see tables below). Furthermore, over the recent years we have seen a sharp rise in political risks in a number of emerging market countries. Political risk is inherent to emerging markets and from time to time, this risk will manifest itself and political turmoil will erupt again. But this is mostly priced in by now. In addition, financial markets have come to terms with the idea that political risks are not only inherent to emerging markets anymore. This supports positive sentiment towards emerging markets. On the one hand, there are a number of factors that will probably put downward pressure on emerging market currencies such as lower commodity prices. Commodity-linked currencies are the most vulnerable for this.
…but commodity-linked EM FX are at risk
Commodity-linked EM FX are at risk in our view. There are quite some forces that will keep a lid on the currencies. For a start, we see downside risks to a number of commodity prices. We expect a more than 10% drop in oil prices and iron ore prices (precious metals are under revision) until the end of June. We also expect a 2 to 9% decline in the base metal prices compared to the current spot level. These price declines will most likely drag down currencies of the countries that export these commodities, such as Brazilian real, Russian ruble and the Chilean peso. Meanwhile, speculators have substantial long positions in the Russian ruble, Brazilian real and the South African rand. Weaker commodity prices will probably trigger position liquidation, sending these currencies lower. In the case of the Russian ruble investor expectations that the Trump Administration would ease sanctions to Russia have resulted in a substantial rally in the ruble (next to higher oil prices). We judge that investors are too optimistic on this front and it is likely that they will be disappointed. This combined with a lower oil price should lead to a substantially lower ruble.
…meanwhile trade-linked Asia EM FX to be resilient…
We expect trade-linked EM FX to be more resilient than commodity-linked FX. Although we expect CNY depreciation versus US dollar to continue, reflecting longer-term considerations, we have upgraded our end-2017 USD-CNY forecast, from 7.15 to 7.00. This mainly reflects institutional factors, as we expect the Chinese authorities to have become more sensitive to keep CNY depreciation limited versus USD in order to prevent criticism from the US and to limit the risk of protectionist measures. It also reflects the PBoC’s shift to a moderately tighter monetary policy.
Countries in Asia such as South Korea, Taiwan and Singapore are highly dependent on the outlook for global trade, especially with China, and the outlook for the global economy. In fact, these countries are currently benefiting from the uptick in global trade, see our Asia outlook, Trade gains outweigh Trump risks, published earlier this week. As they are in general commodity importers, lower commodity prices will be beneficial for them. Next to the global trade and economic outlook, overall investor sentiment also remains a crucial driver. Our new forecasts in the table below reflect our adjustment in the US dollar, in the Chinese yuan and our global economic, global trade and commodity views.
…as well as European trade-linked FX
We remain optimistic for currencies of central and Eastern Europe. For a start, the economies of Hungary, Poland and the Czech Republic have done well (because the eurozone has done well). Output gaps are closing and unemployment rates have lowered which increases pressure on inflation. However, in the near term economic growth in the countries will likely ease, cooling expectations of tighter monetary policies in the coming months. So we do not expect these central banks to tighten monetary policy in the first half of 2017 and this should weigh on the Hungarian forint, Polish Zloty and Czech Republic.
However, it is likely that in the second half of 2017 these central banks will start tightening monetary policy, well in advance, before the ECB tapering expectations in Q4 2017. Therefore, we expect these currencies to outperform the euro in Q3 and Q4 2017. The Czech Republic has the strongest political and economic fundamentals in our view. We expect the central bank in the Czech Republic to end the floor in EUR/CZK in Q3 2017. To avoid a sharp appreciation of the Koruna the central bank will probably intervene in currency markets.
The economic and political fundamentals are more uncertain in Poland and Hungary. Therefore, these currencies will probably not outperform the euro in 2018. These currencies are also vulnerable to a sharp deterioration in investor sentiment towards the eurozone. We expect eurozone political risk to ease and this should support Eastern European countries. However, a possible Italian election remains a wild card though. Such an event could weigh on investor sentiment. Despite this risk we do not expect a revival of the eurozone crisis and contagion to the region.
After the failed coup in July 2016, the lira tumbled. The CBRT did not put enough effort in stabilizing the currency because of political pressures to keep rates low. On 16 April 2017, Turkey will have a referendum to replace its parliamentary system with a stronger presidency. Therefore, we expect the Turkish lira to weaken in Q2 and Q3 reflecting the focus on political risks in Turkey again. Later on, political unrest will probably ease and it is likely that the central bank will have more room to manoeuvre.
To reflect all of the above the table below shows the changes in our forecasts in red.