EM currencies: the ill-fitting cap

Yvan Berthoux - 12 July 2018

The dumping of emerging market currencies over the past 2 months is reminiscent of the taper tantrum episode in May-December 2013, but with crucial differences. In 2013, EM currencies of countries with external deficits suffered a depreciation roughly 5 times larger than those of countries with external surpluses.  In 2018, there is hardly any difference. This lack of discrimination suggests an opportunity.

After the release of QE3 in September 2012 and then in December 2012, the Fed purchased US$85bn per month of US Treasuries, adding MBS at the beginning of 2013. The announcement of a potential ‘QE Tapering’ by the Fed chairman Ben Bernanke on 22 May 2013 triggered an aggressive sell-off in emerging market assets, in addition to an immediate repricing of US Treasuries. Figure 1 (left frame) shows that the US 10-year Term Premium, developed by Adrian et al. (2013), accounted for most of the move in the 10-year nominal bond yield; the TP rose from 60bps after the May announcement to 150bps in mid-September, lifting the 10-year yield from 2 to 3 percent. On the other hand, the expected real interest rate r*, remained steady during that same period at around 1.5 per cent (figure 1, right frame).

We know from empirical studies that a sudden increase in US long-term yields brings a tightening of financial conditions globally, inflicting particular damage on EM economies that are highly leveraged in US Dollars (i.e. large US$-denominated debt). The motivation for examining the relationship between the TP and EM assets, especially currencies, is due to the sudden requirement of a higher yield from US non-resident holders for holding interest rate risk. As the moves in the TP are more pronounced (relative to the more gradual moves in the expected real interest rate), the consequences for EM assets are different.

Figure 1

Data Source: Adrian, Crump and Moench (2013)

EM currencies suffered significant damage during the taper tantrum episode, depreciating up to 15 per cent versus the US$ by the end of 2013. During summer 2013, the term ‘Fragile Five’ had become sell-side analysts’ favourite description of the EM world, a term which referred to five EM countries where currencies experienced important sell-offs after Bernanke’s speech (Turkey, Brazil, India, South Africa and Indonesia).

Superficially, there are parallels with 2018 and the gradual shrinkage of the US Fed balance sheet. However, if we separate EM countries based on their external balances, we can see that the narrative does not fit. For instance, Pictet AM created two portfolios of equally-weighted EM currencies (versus US Dollar), looking at the performance of countries experiencing current account surpluses (CAS) versus current account deficits (CAD). We notice a severe divergence between the two baskets in 2013; currencies of countries experiencing CAD depreciated by 15 per cent in the May-December period, while CAS currencies were down by a mere 3 per cent (figure 2, right frame). This year, as shown in figure 2 (left frame), the US Dollar appreciated strongly against both the CAS and CAD baskets, strengthening on average by 6 per cent and 9.4 per cent.

In addition, if we look at the daily times series on the 10-year yield, we notice that it was the rise in the expected real interest rate that lifted the 10-year yield from 2 per cent in September 2017 to the current near-3 per cent level. On the other hand, the term premium has been trending lower over the past year and is now at -55bps.

Figure 2. EM FX vs. USD (Current Account Surpluses against Current Account Deficits)

Source: Pictet Asset Management

To conclude, two observations emerge. First, that the composition of the rise in US bond yields is very different in 2018 relative to 2013. Second that the Euro has performed as poorly as the EM external deficit countries since mid-April, down 5.9 per cent against the US Dollar. Hence, as our fundamental outlook remains bearish for the US Dollar in the medium term on the back of a deterioration of the US twin deficits (see here), we think that going long the CAS currencies at current levels could be an interesting trade. While the pressure on EM currencies could still intensify (a risk-off response to the uncertainty created by the escalation of threatened trade restrictions and tariffs that favours the US Dollar), a stronger case can be made that the US Dollar remains in a structural bear market. Targeting CAS currencies of countries where inflation expectations remain well anchored presents a good opportunity to capture both the carry trade and potential EM FX appreciation.

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