EM FX update

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EM FX is now stronger than pre-referendum levels. The key question is where do we go from here? While the belief that Brexit is not a systemic, one-off risk event has become prevalent and aided the rally, we still recommend approaching EM FX with caution, particularly at these levels. In sum, we believe we are entering an environment where EM rates (and credit) could rally because of yield compression, but EM FX remains more volatile and somewhat directionless. There are three reasons for this:

1) Fed pricing is now quite dovish. If Brexit is a contained UK event and not a systemic issue, the risk is skewed towards a data-driven Fed repricing higher from the current dovish levels (first full hike priced for October 2018). In this respect, upcoming US data, e.g. Friday’s NFP, are crucial (a point highlighted in last week’s FX Daily). We have seen in the recent past that these repricings can occur quickly, and have a large negative impact on EM FX; in May for example, EM FX sold off sharply in line with Fed repricing higher (Chart 1). Even if the Fed eventually does not hike in the near term, the path to this is unlikely to be a straight line – rather, we can expect the recent volatility in Fed pricing to continue, taking EM FX along with it.

2) Even if we accept the thesis of lower core rates for longer, which is positive for EM rates and credit because of yield compression, this is not necessarily an outright positive for EM FX. First, there is still considerable uncertainty around UK/EU politics, Italian banksand Brexit implications, and negative headlines around these are likely; EM FX is generally the liquid shock absorber that reacts first to any adverse headlines or shifts in risk sentiment. Second, EM FX is more sensitive to the US short-end, while EM rates are likely more sensitive to the long-end: while a repricing in the short-end is possible, the long-end could remain relatively well anchored (as has been the case in the recent past) – this is an environment where EM rates and credit could remain well supported but EM FX is more directionless. May price action is again informative in this regard: US short-end repricing higher triggered EM FX depreciation, even though EM credit and rates remained stable (Charts 2 and 3).

3) Lastly, EM FX is more sensitive to growth, and concerns about both domestic and global growth remain. If for example core yields stay low due to weaker global growth, this is not necessarily an outright positive environment for growth-sensitive EM FX. On the domestic front, EM growth is also not showing significant positive impetus (Charts 4 and 5).

The above three points do not mean we are outright bears on EMEA FX. With positioning not stretched, there is potential for this rally to continue. However, the above points do suggest caution is warranted (Chart 6). In this environment, we focus on finding pockets of value rather than chasing the rally ‘all in’, i.e. being long currencies which should remain relatively insulated from the key external shocks, and where the idiosyncratic trajectory and valuation is attractive. RUB is one currency that falls into this category in our view, and we recommend staying long RUB vs. basket (EUR + USD), a trade we highlighted in the FX Blueprint and which has performed well thus far.

1: In May, EM FX reacted very negatively to the Fed repricing higher

2: A repeat of May is possible, when EM credit remained well supported but EM FX sold off with Fed repricing

Source: Deutsche Bank

Source: Deutsche Bank

3: EM local bonds performance: May saw stability in local bonds but a significant selloff in EM FX

4: Growth vs. FX performance among ‘high yielding’ EM FX: growth is a key driver of EM FX…

Source: Deutsche Bank

Source: Deutsche Bank

5: …But EM growth is slowing, as confirmed by our macro momentum index (a combination of high frequency activity indicators)

6: EM Risk Monitor is in risk neutral territory (far from risk on), suggesting caution in chasing the EM FX rally

Source: Deutsche Bank

Source: Deutsche Bank

Long term suggestions “signals”

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As a function of the UK’s “Leave” decision at the June 23 Brexit referendum, our economists have materially downgraded their expectations for the UK and European economies vis-à-vis the rest of the world. In the same context, we are making material revisions to our FX forecast set.

Having been wrong about the outcome of the referendum, we are lowering our 3m GBPUSD forecast to 1.22 from levels 1.58 previously. This is consistent with the “leave” outcomes we expected when we previewed the possibility back in January. Nonetheless our trade portfolio gained on the week, given our long held short GBP hedge established when still cheap.

We are lowering our 3m EURUSD forecast to 1.05 from 1.17 previously. Our former forecast had anticipated a general jump in European currencies which were all pricing in some degree of Brexit contagion risk premium. Now the bad outcome is realised, we suspect the market will be consistently looking to sell EURUSD rallies.

We are not risk averse across the board – we see this as mostly a European problem. As such we add the following trade recommendations to our portfolio.

1.     We recommend buying a 30 Aug 2016 EURBRL put spread, strikes at 3.7300 and 3.5600 for net 2.1% of face value (spot ref: 3.6540).  The maximum net gain is around 2.7% if spot finishes at or below our lower strike at expiry. The maximum loss is limited to the net premium paid.

2.     We recommend buying a 29 Aug 2016 expiry EURRUB put spread, strikes at 72.30 and 68.80, for net 2.2% of face value (spot ref: 70.98). The maximum net gain is 2.8% if spot finishes at or below our lower strike at expiry. The maximum loss is limited to the net premium paid.

Trading in Volatile Markets

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We would like to take this opportunity to remind you of the measures Bank of America Merrill Lynch (BofAML) has in place for trading in volatile market conditions.

In periods of extreme volatility, we have on some occasions seen delays to trades, including requests for quotes (RFQs), order taking, order processing, price streaming and/or market data dissemination.  As a reminder, we are not obligated to provide price streaming, respond to RFQs, or accept orders for execution in any particular manner, and all determinations of if, whether, or when market criteria have been met for execution shall be made by us in our sole discretion.

BofAML’s electronic trading platforms have volatility controls that may temporarily suspend execution and price streaming in response to rapid and adverse market movements.  It is possible that different clients submitting orders or requesting trades with similar profiles may achieve different outcomes, including whether and when orders or trades will be executed.

During volatile markets, we will endeavour to continue to serve clients but we may not be able to provide the product offering, level of execution, liquidity and pricing – including in electronic markets – as would be the case under more normalized market conditions.

EUR-JPY: Real breakout! Signal Longterm

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The indecisive price action of late came to end last Friday with the steep decline in governments bonds around the globe triggering major moves. Flight to safety can be seen in record low bonds’ yields, together with strong gold, JPY and CHF through falling EUR-CHF.

EUR-JPY has broke out of its recent range of 122-124.44. Please find attached the daily chart. After several false breakouts in recent weeks, this is a genuine breakout that shall see the pair trading much lower eventually, although another climb towards 122 is still possible. 

Now: 119.52

Next stop: Daily close sub 120. 

Victory FX is the owner and developer of the Orbits theory and algorithm. It specializes in identifying genuine (from false) breakouts which trigger major price cycles from their very beginning with exceptional probability of 90%  about 10-14 times in a year. Trading universe includes: G10 currencies, gold, silver, oil and US bonds. R&d: 7 years.