Fear, risk and value in emerging market currencies

By Matein Khalid, global equities strategist and fund manager

The $5 trillion global foreign exchange market is hyper-sensitive to shifts in the ultra-easy money policies of the G-7 central banks. So it is no coincidence that the prospect of another Federal Reserve interest rate hike has led to a volatility spike across emerging markets. This has an immediate impact on risk sensitive, high yield emerging currencies and international capital flows to Third World local debt markets at the merest hint the central bank money pump will slow down. This is exactly what happened last week. ECB President Mario Draghi dissed the prospect of additional quantitative easing. Boston Fed President Eric Rosengren called for a Federal Reserve rate hike this autumn. The Bank of Japan faces technical limits to its “shock and awe” monetary easing now that Kurodasan has nationalised both the Yen bond market and the Nikkei Dow. This led to a spike higher in global bond yields, a spike higher in emerging market currency volatility and a steeper US Treasury bond yield curve.

When volatility rises in the foreign exchange market, high yield commodity currencies most sensitive to risk/flows are immediate victims. This is the reason the Canadian dollar was a highly profitable short at 1.29 and the loonie has fallen to almost 1.32 as I write. I still contend that the Canadian dollar can fall to 1.36 this winter if Saudi Arabia, Russia, Iran and Iraq do not negotiate a convincing output freeze at the Opec Algiers meeting.

Emerging markets currencies can tank when volatility and risk aversion rises in the global markets. For instance, the South African rand lost six per cent from early August to its recent 14.75 September low, yet the Russian rouble has shown a lot more resilience at 65 despite the fall in crude oil and Western sanctions related to the Kremlin’s war in Ukraine and annexation of Crimea. I can easily envisage a fall in Russian rouble to 68 as Bank Rossiya slashes rates.

A CNBC-TV18 report hinted at a potential devaluation of the Indian rupee. This was denied by the Finance Ministry but the rupee sank to 67 against the US dollar. The RBI has called commercial banks to check their dollar positions and Trade Minister Sitharaman has denied the report. However, it is undeniable that the dramatic drop in Indian G-Sec yields, another repo rate cut and a Fed rate hike portends rupee weakness. I expect the rupee to trade in a 66-68 range in the next six months.

President Duterte’s political bombshells have triggered a spasm of foreign selling in Manila equities and Philippines peso debt. The fall in the peso to almost 48 is excessive given the sheer scale of OFW remittances and the $30 billion outsourcing industry. This could be an opportune moment to buy the Philippine peso against the Thai baht in the NDF forward market.

The Mexican peso is the most undervalued currency in the emerging markets, thanks to the prospect of Fed rate hikes and Donald Trump’s poll lead in Ohio. The Mexican peso is extremely cheap at 19.2 against the US dollar, having lost almost three per cent last week alone. This is now an extreme, crowded short trade that bears no relation to macroeconomic logic, though I concede a Trump win would be a disaster for Pobre Mexico! Gringolandia politics precludes a major buying base for the Mexican peso which can well depreciate to 20 in October.

The Russian rouble plunged from 30 to 85 after Vladimir Putin invaded Ukraine, annexed the Crimea and moved to a free float currency regime at the precise moment oil prices tanked, devastating the Kremlin’s revenue base. Russia has now suffered its biggest recession since Boris Yeltsin’s banking crisis in August 1998. Russian rouble implied volatility is far too low at 13 given that it was 26 last December. Russian Eurobonds and Russian equities were among the world’s best performing asset classes in 2015 – and the rouble rose 14 per cent against the US dollar in 2016 despite stagnant oil prices and Western sanctions. The Russian rouble is now overvalued at 65 as the economy continues to contract and Russia’s inflation rate is the world’s highest save Belarus and Zimbabwe.

Money market futures signal a 50 per cent probability of a December FOMC rate hike – and there could be two rate hikes in 2017. This means a one per cent Fed Funds rate and King Dollar at full throttle. This will be the time G-10 and EM currencies plunge. How far? Loonie at 1.50. Aussie 0.64 cents. Sterling 1.15. Get real, get out.


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