The next big risk to fear is the capitulation of real-money investors, who could pull funds from local bond markets en masse, according to Benoit Anne, head of EM strategy at Société Générale.
“This is a serious risk for previously popular investment destinations such as Turkey, Hungary, Russia or Mexico,” he says.
Anne says the latest data on foreign investor participation in EM bond markets continue to point to relatively heavy positioning on the part of international investors.
“This raises a significant red flag,” he says. “We are now bearish outright on most EM currencies, and no longer recommend exposure to EM bond markets.”
The violence of the move in EM FX markets has seen a truce called in the global currency war, with EM central banks, particularly in Latin America, stepping into the market to support their currency rather than contain appreciation pressure.
The main catalyst for the capitulation in EM FX has been the rally in global bond yields triggered by speculation that the Federal Reserve is starting to consider scaling back its massive quantitative easing programme.
John Normand, global head of FX strategy at JPMorgan, says even though the global bond market rout witnessed in May was only the third worst since the post-Lehman era, it was the most disruptive, judged by the rise in equity, rate and FX volatility, and contagion to emerging markets.
He says rises of 50 basis points in 10-year US Treasury yields – they have risen 45bp since May 1 – occur fairly regularly, but, as the chart below shows, contagion to EM local markets on the current scale is a rarer event.
| Brutal sell-offs in treasuries and EM local currency debt |
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“This month’s vol moves are unusual too, highlighting how much more disorderly the rate sell-off has become,” says Normand.
“For the first time in four years, a US rate move is pushing equity and EM FX volatility higher, and while US rate vol has always risen during Treasury sell-offs, the magnitude of this month’s rally is the second strongest of the past six episodes.”
Rising volatility in Japanese rates is not helping either. The Bank of Japan’s contradictory promises at the start of April to buy massive amounts of JGBs to push yields lower and to achieve 2% inflation in two years, has resulted in JGBs becoming almost as volatile as US treasuries for the first time in a decade.
That is a development that undermines high-yielding EM currencies, given that Japanese investors are unlikely to increase their foreign asset purchases when their domestic markets are becoming higher-yielding as well as unruly.
Still, as can be seen in the chart below, it has been the prospect of the Fed tapering its asset purchase programme, rather than developments in Japan, that has had the most bruising effect on EM currencies.
The South African rand is down more than 10% since the speculation over the Fed scaling back its asset purchases intensified at the start of May, while Latin American currencies have also suffered sharp losses.
Asian currencies have been more resilient, but in EMs only the renminbi, Czech koruna and Hungarian forint have outperformed the dollar. That reflects position adjustment that has seen the return of correlation in the FX market, with funding currencies such as the forint and koruna benefiting as investors unwind positions.
| EM FX performance since April 4 and May10 |
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The potential normalization of US rates, even if it is orderly, threatens to weaken portfolio flows into EM, which in turn could prompt further weakness in EM FX on top of the recent violent price action.
In that contest, it is worth noting that Malaysia and South Korea benefited from the largest increase in portfolio flows in the last six years, some of that coming from real-money investors such as central banks and sovereign wealth funds.
Meanwhile, among currencies that attract the most speculative interest in EM, the South African rand and the Mexican peso saw increases in foreign holdings of public sector debt worth 6% of GDP as at the end of 2012 when compared to the average between 2007 and 2012.
JPMorgan has added the balance-of-payments financing gap to the, admittedly extreme, scenario that foreign investors cut back their holdings of EM public sector debt to the average levels that prevailed between 2007 and 2011.
As the chart below shows, the bank found that the South African rand, with a potential financing gap of 12%, was the most vulnerable currency to a reversal of foreign bond holdings, and the rouble the least. Across EM, the financing gap would range from between -4% of GDP to -12%.
“Positioning aside, we are wary of widening current account deficits in commodity countries amid growth deceleration,” says Bert Gochet, strategist at JPMorgan. “For those countries with headline inflation below targets – such as Chile, Colombia and Peru – currency weakness should be used as the main buffer for the adjustment to lower terms of trade.”
| Foreign holdings of local public fixed income securities |
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The catalyst for turning the current rout in EM currencies into a more permanent turn in sentiment is what happens to those real-money flows that have supported local bond markets.
For some, the signs are that a change has already occurred that will alter the investment landscape in the coming years.
Simon Derrick, global head of FX strategy at Bank of New York Mellon, the world’s largest custodian bank, says there has been a fundamental change of attitude towards the dollar in the past two years from EMs.
Between 2002 and 2010, accelerating outflows from the dollar and growing inflows into emerging and developing market nations fed through into accelerated FX reserve growth in these countries as they fought against currency strength.
However, Derrick says one of the most notable features of the financial markets since the summer of 2011 has been a marked slowdown in the quarterly FX reserve growth of those countries.
Data from the IMF showed reserve growth hitting a post-financial crisis high of $399 billion in the third quarter of 2010, and it remained elevated until the second quarter of 2011, when it hit $131 billion.
Since then, however, the broad trend has been sharply lower, with three of the next six quarters registering net outflows, while the other three showed net inflows of just $152 billion.
“Although we have yet to see the IMF number for the first quarter of this year, all the indications are that, ex-China, the reading should come out not that far from flat,” says Derrick. “In short, the outflows from the dollar appear to be drying up.”
Derrick says signs of a change in attitude towards the dollar are also evident in the BNY Mellon’s own custodial flow data.
He says while the period of the financial crisis was characterized by inflows back into the dollar, from March 2009 through until May 2011 there were accelerating outflows. While the subsequent 16 months proved mixed, the story since September of 2012 has been one of steady inflows back into the dollar.
“None of this is to say that the path for the dollar from here will be unremittingly higher,” says Derrick. “However, what we do think it means is that the support that emerging market currencies and asset markets have enjoyed for so long may no longer be there to anything like the same degree.
“This is the real message that emerges from the sharp losses being seen in currencies such as the South African rand, the Mexican peso and the Turkish lira in recent weeks.”
In other words, for EM FX, after a series of violent falls and recoveries since the financial crisis, this sell-off really could be different.