EM FX has outperformed both EUR and JPY

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Jan Dehn, head of Research, at Ashmore, discusses how Emerging Markets (EM) FX has outperformed both EUR and JPY during this fit of USD exuberance, but the USD surge needs new drivers to keep going or momentum is likely to weaken.

EM FX has outperformed both c and JPY. Clearly, the USD has been bought against all other currencies in the world. While powerful, we think the USD surge has somewhat flimsy drivers. There have been at least four different drivers of the USD rally since it began on 1 July.

First, the USD rose on expectations of stronger US growth after the Q2 growth rate of 4.2% and the Fed’s forecast for a first rate hike in Q1 2015. This view then quickly gave way to fears of a Fed policy mistake that briefly caused the VIX to spike and crashed the US stock and corporate high yield markets. Ironically, this fuelled further demand for USDs in the usual knee jerk flight to liabilities reasons.

Next, came a strong tailwind as Fed officials moderated their rhetoric about rates, which led to renewed hopes for stronger growth. Most recently, the USD has been aided by ferocious front-running of a major portfolio shift by the Japanese government pension fund (see discussion below) as well as hopes for QE in Europe.

It is a zero-sum game between EUR, JPY and the USD and EM currencies have very much been caught up in the momentum, but featuring prominently in the narrative. This is one reason why EM local bond yields have actually declined since early July and why EM external debt has outperformed US government bonds of the same duration by 370bps this year.

This year’s “Tightening Tantrum” is, in other words, very different from last year’s “Taper Tantrum”. But these two, along with the other recent tantrums – the eurozone debt crisis in 2011-12 and ‘Abenomics’ in late 2012 – have one thing in common: They all involve purchases of USDs and sales of other currencies. USD longs get ever more pregnant. This is a negative technical that will eventually unwind, but probably not until everyone is up to the limit on USD exposure.

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