Window Of Carry Sees Renewed Interest In Emerging Market Currencies

Markets are enjoying some temporary calm and cross-market measures of volatility are sinking back to levels seen in early June. Barring an explosive US July CPI release or some major escalation in the straits of Taiwan, these calmer conditions can see renewed interest in emerging markets (EM), including in EM local currency bondsh2 U.S. Dollar stability can allow some interest in high yield EMFX/h2

A very quiet Monday and Tuesday has seen the dollar soften slightly across the board. The moves have not been particularly large, but we have seen steady out-performance in currencies like the Brazilian real, Mexicn peso and a few selected commodity-linked currencies in the G10 space. The moves are a reminder that FX markets never fully settle and that even in quiet periods, investors rotating into yield can generate some movement.

An FX trend that is probably worth watching is whether investors start returning to the battered EM local currency bond complex. On a global basis, aggregate EM local currency bond benchmarks are down around 8% year-to-date (better than equity benchmarks). Yet that 8% drop masks regional differences. EM Latam (dominated by Brazil and Mexico) is up 2% year-to-date, while EMEA and Asia are down 23% and 6% respectively.

Even though we think the dollar can stay quite well bid for the rest of the year as the Fed takes the funds rate to 3.25/3.50%, dollar stability at the highs could see renewed interest in this high-yield EM local currency bond space. Of these geographical blocs, we are already starting to see sizable bond market rallies in Latam, where the fall in US Treasury yields is being accompanied by views that some of the pre-emptive hikers – such as Brazil – have just about finished their tightening cycles. These views are being helped by the sizable turns in some of the big inputs in EM. For example, the UN's FAO world food price gauge dropped to a 13% year-on-year increase in July, from peaks of 40% YoY last summer and 35% YoY in March on the back of the Ukraine conflict. Energy price inflation is slowing too.

Quiet summer markets could therefore see investors starting to position at the long end of the EM local currency bond market for EM easing cycles coming through next year. Here many think Brazilian policy rates have peaked at 13.75%, while Mexican rates should peak alongside the Fed in December this year – probably in the 9.25/50% area. Given heavily inverted yield curves, bond investors will have to leave FX exposure open to these bond investments – meaning that a flow into this product could see some sizable FX rallies. Brazil has elections in October, adding to the complexity here, but a pick-up in flows to the EM local currency product could certainly help the MXN – where USD/MXN could trade back to 19.50 as could EUR/MXN.

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Back to DXY, expect another range-bound day as the market awaits the US July CPI release – a release expected to cement expectations that the Fed Funds rate will be taken to the 3.25/3.50% area by year-end.

EUR/USD remains listless in the middle of a 1.0100-1.0300 range. The European data calendar is exceptionally light this week and this pair will instead be driven by geopolitical factors and US data/Fed speak. Our baseline for the remainder of this year is EUR/USD continuing to trade down near the 1.00/1.02 area. Italian politics will also prove a headwind into the September elections. Having said that, the Italian-German 10-year bond spread was quite contained recently, despite Friday's ratings outlook change for Italian sovereign debt by Moody's. Presumably, the ECB's flexible use of pandemic emergency purchase programme (PEPP) re-investments aims to limit the fall-out on Italian bonds for the time being.

EUR/GBP is pressing resistance at 0.8450 as we write this. We had felt that this might prove the top of a near-term trading range – despite the Bank of England's bleak prognosis last week. In our mind, there still does not seem a compelling case for EUR/GBP to trade substantially higher, but we acknowledge that a break of 0.8450 can carry EUR/GBP to the 0.8485/8500 area.

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Written By: ING Economic and Financial Analysis