Forex Investment and Currency Trading

Since mid-September, emerging market currencies have depreciated versus non-USD majors by 2.5% on average. This shift is coming after about 2 months of flat performance between EM and G10, which in turn followed an out performance of EM currencies within July. In general, EM FX moves have been related with broader USD trends. EM currencies were rallying during the first stage of the USD rally, from late July to early August. Markets started re-assessing lower the growth prospects
outside the US OECD.

In the process of downgrading ex-US growth expectations, an increasing number of long term US investors started to either cash out or hedge their investments in foreign assets, which brought the second stage of USD strength, from mid August to early September. During that time, emerging market crosses were weakening versus the USD but no more or no less than
non-USD majors on average.

More recently, the underperformance of EM currencies appears to be (1) broader based, and (2) more linked to the underperformance of local assets. It has come at a period of a weaker dollar (mostly vs majors). It has also been accompanied by a spike in EM FX vol. Despite the coinciding increase in G10 vols, EM vols have recently increased more comparatively. EM
vols are now trading very close to G10 vol levels, while for the most part of the last year they have been trading well below G10 vol levels.

It is NOT Fundamentals that Are Driving EM FX Down

The most recent news flow from EM fundamentals has not altered the macro outlook for emerging markets. There may be evidence of slowing growth in some places (as there is, notably, also evidence of growth accelerating in others), however the slowdown is only moderate so far and even at current levels, EM growth is still on average much better than G10 growth. Even though broader risky assets (like local credit or stock markets) can come under pressure, EM FX is still compelling from a fundamental standpoint. This is partly due to the positive growth differentials for EM economies with G10.

Inflation has been either moderating or showing early signs of a peak across many EM countries. And even for the ones where inflation seems to remain an issue, the ongoing decline in food and energy commodities gives markets re-assurance that inflation rates will start declining eventually. Inflation relief (combined with resilient growth) is friendly for local
bonds and currencies.

From the policy side, with the exception of some noise in South Africa that has not had much directional effect on the volatile ZAR, EM policy makers are beginning to focus on the potential impact of the turmoil in G10 economies and the impact it could have on local economies. More specifically, EM central bankers have been focusing much more on potential growth spill-overs (a trend which could have positive implication for the world more broadly).

Interestingly, EM rates have been quite well-behaved during the recent turmoil and the inflation relief theme continues to provide support for lower rates (without it necessarily implying lower real rates).

Positioning and Risk Sentiment Could Turn more Favourable for EM

Positioning liquidation, repatriation of capital and negative risk sentiment have arguably been among the key drivers behind the broader underperformance of EM assets and EM FX more recently. However, anecdotal evidence and price action across local assets suggests that, if anything, long positions in emerging markets have been scaled down significantly.

Flow and positioning based variables remain the key unknowns in terms of FX strategy. However, to the extent that broader USD trends imply that the process of repatriation of US capital may be temporarily losing momentum then perhaps the recent violent adjustments in EM positions that led to EM weakness may also be fading.

With fundamentals remaining EM FX supportive, this could give a good entry point to fresh long EM FX positions. Uncertainties surrounding the approval of the Paulson plan could raise the levels of volatility across markets. However, a potential approval of the plan should eventually support sentiment for risk assets. This could provide a broader support for local EM
assets and lead to fresh outperformance of EM FX.