EM FX update

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

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