Daniel Rico:
Hello everyone, and welcome back to another episode of the Emerging Markets Report. My name is Daniel Rico and I'm joined today with my colleague Dasha Parkhomenko. Hi Dasha.
Dasha Parkhomenko:
Hi Daniel.
Daniel Rico:
So one topic that has been coming up with our client recently is the increase and the steepening of the US yield and the rise of US breakeven inflation this year. The stronger economic data and the US is reviving the reflection trades as Congress debates another stimulus package. These are causing the market to actually question their consensus dollar weakness for 2021 on how much further EM FX rally has room to run. Dasha, to address these questions one metric that I have been watching closely this year is EM index credit spreads that are now only around 20 basis points away from the elusive 300 level. This has been a function of the fed backstop to ease conditions through various liquidity programs. And this has allowed EM credit to outperform EM local currency bonds, rather than improving debt metrics and funding needs in EM which on the contrary have deteriorated.
Dasha Parkhomenko:
That's a very good point, Daniel. So since 2009, EM credit spreads have been able to sustain a move below the 300 level for no more than 90 days in a row. In addition to the EM spreads that you just mentioned, we have also seen a significant easing of US financial conditions and the piece of which the EM credit spreads have tightened and financial conditions have eased does raise the question of when the turning point will happen. What do you think about the turning point?
Daniel Rico:
That's true and a good point, but it is difficult to attach a time on the turning point. The fed has been very clear that they will not raise interest rates anytime soon, but I do actually think that minor changes in the Fed communication can still translate into higher credit spreads and ultimately tighter financial conditions. Having said that, the hurdle for this to happen remains high at the moment with financial conditions likely to remain easy.
Daniel Rico:
But a repeat of the 2013 taper tantrum is possible as the US economy shows some levels of normality in the second half of the year. One can even argue that global financial markets are already starting to resemble the pre 2013 taper tantrum period as US financial assets to start to price a full recovery.
Dasha Parkhomenko:
I agree with all of those points, I think an economic recovery in the US and also small changes in the Fed's language would be potential drivers for financial conditions to tighten.
Daniel Rico:
If this starts to play out, do you think there will be differences in how the different EM regions and countries will react to tighter US financial conditions?
Dasha Parkhomenko:
Yeah. So if we calculate the sensitivity of changes in EM FX total returns versus the dollar to changes in US financial conditions, we can actually find a few interesting takeaways. First, the average EM FX change on a total returns basis in response to tighter financial conditions is larger than change to easier financial conditions.
Dasha Parkhomenko:
The second takeaway is that the FX responses do vary by region. If we drill into specific currencies, Latin American currencies, and commodity producers in general, such as the real, rand, and ruble, tend to have the highest sensitivities across EM. While the Asia EM region appears to be the least sensitive to changes in financial conditions and actually in both directions, whether conditions are tightening or easing. As you mentioned before, it is of course, difficult to time whether your financial conditions will tighten and most likely for now, the conditions will remain easy in the current environment of ample liquidity and a fed that's unlikely to raise rates anytime soon. But the risk reward, the risk reward is starting to look asymmetric and when that reversal happens, based on these sensitivities commodity producers, especially in Latin America, are likely to underperform currencies which are less sensitive to changes in US financial conditions such as Asia EM. And that might be a more interesting way to position for reversal in financial conditions than just simply defaulting to a long dollar EM position.
Daniel Rico:
I agree, Dasha. This will be definitely a very interesting topic of discussion as the US economy recovers. Thank you and thank you everyone for joining and we will see you next month.