“The extent of actual tightening is debatable in some cases, but overall we probably would have expected a more positive asset-market reaction to the EM central bank moves, but instead we are seeing AUD threatening recent lows, NOK close to the July 2013 medium-term peak, CAD near recent highs, equities selling off, and JPY finding support [from carry trade funding],” says Steven Englander head of G10 FX strategy for Citi, in New York.
“Investors fear that the EM central banks have fired their last shot, and will be unable to follow through with more tightening, or that their economies/politics are too weak to support rate hikes, but either way the contagion to less-liquid, high-beta G10 currencies is very direct.”
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Certainly, against a backdrop of soft China data, and continuing weakness in the US equity markets, the surprise devaluation of the Argentine peso took on a much greater significance than otherwise it might.
The S&P 5-Day Rule, correct 80% to 90% of the time, posits that if this index finishes the first five trading days of the year positive, then it will finish the year positive. If it’s negative, then it is a coin toss as to how it will end.
“A big crisis can have very small beginnings,” says Alan Ruskin, macroeconomic strategist for Deutsche Bank, in New York. “Remember that Thailand was only 0.5% of global GDP in 1997, so watch out Turkey, Brazil, Indonesia, and India.”
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In 1997, he adds, even China’s economic stability – it had been averaging around 10% GDP growth in the previous five years – was insufficient to offset broad EM contagion.
“Currently, China is the bulwark that stands between S/SE Asia instability and a dramatic broadening of contagion encompassing the global economy, and China’s share of global GDP is now four times what is was in 1997,” says Ruskin.
“If contagion stretches to China’s credit cycle, it would represent a huge escalation in contagion risk.”
As an adjunct to this, although the yen and the Swiss franc are benefiting once again as principal funding sources for a resurgence in carry trades, such strategies can blow up dramatically, especially when exacerbated by exotic risk management – in the late 1990s, barrier options were exotic, and played a role in USD/JPY’s 20 big-figure slide over three startling days in October 1998, just as long China carry exposure is fashionably exotic now.
Additionally, in terms of the EM carry market, the size of buy-side positions must be seen in the context of a sell-side of the Street, which is still challenged in terms of providing its traditional liquidity-supplying role, says David Simmonds, head of currency strategy for RBS, in London.
“Cost of capital, risk-weighted asset reduction and regulation are all areas of intense focus for banks generally, and a much bigger buy side combined with a more inhibited sell side is potentially a potent brew for market uncertainty,” he says.
“And narrow-exit risks can become no-exit reality for the most populated global carry positions.”
In this context, adds Simmonds, currencies such as the Mexican peso might be more prone to positioning adjustment and currency correction than relatively strong fundamentals otherwise suggest, and the Polish zloty might be another example of something that is owned and therefore can be sold.
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It is true that much of the recent underperformance of many currencies is idiosyncratic, due largely to home-grown political and economic problems, such Argentina, Thailand, Turkey, Ukraine, among others, according to Marc Chandler, global head of currency strategy for Brown Brothers Harriman, in New York.
However, he adds: “The perceived receding of global capital flows has perhaps exposed and magnified the cracks in EM fundamentals.”
In this vein, it would not take much to budge EM currencies further up the risk curve. In general terms, for example, says Citi’s London-based FX strategist Valentin Marinov, the risks for EM currencies in general could linger, and could come back to the fore if, say, data out of China continue to disappoint.
In this regard, on Saturday the National Bureau of Statistics and China Federation of Logistics and Purchasing PMI manufacturing gauge fall to a six-month low of 50.5, only marginally above the figure – of less than 50 – than denotes an actual contraction in output and orders.
Additionally, though, concludes Chandler, markets look vulnerable to smaller shocks as well, as evidenced by the lacklustre reaction to the large (225 basis points) hike in Turkey’s effective policy rate to 10.0%.
“Whilst real interest rates are now decidedly in positive territory, the bank still has a long way to go in order to build up credibility, and Turkey’s fundamental challenges – current-account deficit, low reserves, political uncertainty – are not about to go away anytime soon,” he says.
Overall, says Ray Farris, head of Apac macroeconomic strategy for Credit Suisse, in Singapore, although the recently higher volatility in EM is largely idiosyncratic, medium-term EM will remain under pressure, especially versus the USD.
“Although the indiscriminate phase of selling of EM FX is probably over, the outlook for the asset class remains weak, but a key question is to identify cases where the babies are being thrown out with the bathwater,” he adds.
“So whilst we think that the Chilean peso, Russian rouble and the South African rand are the relatively easier shorts against the US dollar, the Korean won and the Singapore dollar are beginning to offer value.”
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