Carry on...
Photo by Mark de Jong
5th May 2023
This week I will talk about:
The enduring attraction of EM FX-carry despite the chop
NFP, FED and ECB
The US Debt Ceiling
EM Central Banks
Market monitors
Carry on….like the British monarchy
A week loaded with event risk brought no significant change to my approach towards EM FX. Again, I made precious few tactical adjustments around my themes, with MXN and BRL remaining my largest long positions. As discussed last week I like short CNH, and as I’ll mention later I’ve added short USDJPY for balance around the debt ceiling.
The three main EM FX themes I track, that have performed well this year have also been trading sideways in recent weeks. These RV baskets, which I have described in earlier notes, have been trading sideways in recent weeks, relying on the carry component to maintain upward momentum. As you can see below, long Ex-ante real rates has performed best, with all 3 themes benefitting from the high levels of carry on offer.
Looking specifically at the Carry index we can see how high the yield on the basket has become, with the average yield difference consolidating between 8% and 9%. Looking at rates curves, much of EM FX will likely offer a similar level of carry for a while. A glance at ex-ante real rates estimates I made a few weeks ago, you can see these are expected to be high in the coming years, as central banks fight to regain price stability. It’s also worth noting that the yield on the carry basket I track excludes high-yielding RUB and TRY which I omit given their ongoing domestic difficulties.
In the Correlation section of the market monitors I look at the evolution of correlations between these themes and asset prices. This theme-based approach really seems like the optimal way to be long EMFX right now.
NFP, FED and ECB
The three marquee events of the week all passed without getting traders’ pulses racing for more than a few minutes. As I publish we’ve just received a better-than-expected payroll report. This month’s beat comes with a substantial downward revision to last month (which it turns out was a miss). Net strength came in the form of a fall in the unemployment rate to 3.4%
On Wednesday night The Fed delivered what many believe will be their final hike of the cycle. Language changes seem designed to reinforce the message that it will take positive data surprises to induce a further tightening. The market prices modest chances of an additional hike in the coming months, but then significant chances of easing thereafter. From my current position outside of the industry, the extent of the pessimism priced into the US fixed-income market surprises me. I accept that bonds now offer genuine balance to a long-only portfolio now and presumably that has some impact on pricing, along with the tail risks associated with banking liquidity. Nonetheless, this has to be balanced with the risk that sticky core inflation and a stubbornly robust labour market delay the easing cycle considerably. With the significant lags associated with monetary policy transmission to the real economy, there will undoubtedly be a case made for a prolonged pause.
The ECB, who most likely will not be finished for a few more meetings, hiked 25bp as expected. A reduction in the pace of bond purchases delivered a hawkish tilt.
Debt Ceiling
With the Fed, the ECB, and NFP all negotiated – the carry train rolls on toward US debt ceiling angst. For anyone unfamiliar with this, the US government hit its statutory debt limit of USD31.4tr in January, so the question now is when the government will run out of money. They are currently running down the cash-on-hand which stood at over 500bn at the start of the year and was recently topped up by tax receipts. Treasury Secretary Janet Yellen suggested recently that a new deal would need to be agreed by 1st June to prevent a shutdown. This date is earlier than was originally expected by the market, which brings forward the timing of the intense phase of negotiations, which will naturally all take place at the last possible moment.
Despite having traded through several volatile debt ceiling events, the most notable were 2011 and 2013, I usually don’t see them as anything more than theatre. Perhaps it’s because I’m English, perhaps I watched too many episodes of The West Wing during my formative years. From a UK perspective, I look across the pond in envy at the inflation reduction act and at a government that has the room to enact bold policy. As we learned in the brief time between having an ex-Goldman Sachs banker in charge of the Treasury, and his ascent to the Premiership, the UK has constraints on its fiscal largesse. The US has much more room to experiment on this front. The regular debt ceiling episodes seem to give an opportunity to pause and reflect for some, as they should, but the well-drawn battle lines seem to preclude a truly productive debate. This strikes me as particularly relevant at this juncture in the wake of the recent(ly concluded) hiking cycle from the Fed. With the vast and unconventional fiscal stimulus seen during the pandemic, there was clearly an opportunity for similar imagination to be applied towards fiscal policy as the economy began to overheat. It seems a wasted opportunity to not have offered a better-targeted response and helped with debt stock.
Either way – the debt ceiling is going to be the focus of much angst from anyone holding higher-yielding currencies in the run-up. At times like this the USD has historically been bought vs. risk assets like high-yielding EM but has been sold against lower-yielding reserve currencies such as the JPY and CHF. Looking at recent momentum and its much more attractive valuation I suspect JPY will be the favoured choice. I’ve been tempted into adding it to my portfolio as it works on a number of axes with domestic inflation and changing monetary policy adding an idiosyncratic appeal. Other than additional volatility in risk assets in anticipation of a shutdown, a real-economy impact exists, especially if we do see a number of days of shutdown. Any suggestion that social security payments could be delayed, for example, would have a material impact. This has the potential to be a contractionary event and to speed up our journey towards a US recession.
Notable Macro Data
This week we had important updates from S&Ps global manufacturing PMIs. In Asia, we saw the strongest gains in Thailand and India, with weaker readings from Malaysia, Taiwan and Korea with all 3 remaining below 50.
In Latin America, Mexico’s manufacturing PMI remained strong at 51.1 in contrast to a disappointing drop to 44.3 in Brazil. Following the global pattern, the services PMI in Brazil was strong at 54.5
In the US, the ISM Manufacturing PMI rose slightly to 47.1 with manufacturing prices rising more than expected. The Services ISM remained strong at 51.9 with a notable pick up in new orders. Initial claims ticked higher but they maintain their recent ‘slightly’ higher range, and by no means signal a serious turn, although we did have softer news from the labour market from the JOLTS report.
This morning we had the Caxin services PMI from China which maintained its recent strength at 56.4 the manufacturing PMI came in lower than last month at 50.2 with falling new orders.
Central Banks
This week we had meetings in Brazil, the Czech Republic and Malaysia. Contrary to many expectations, Bank Negara Malaysia decided to increase rates by 25bps to 3%. In their statement, BNM sounded upbeat about the domestic economy citing upside risks coming from stronger-than-expected tourism and the removal of domestic price controls and fuel subsidies.
In Brazil, the Selic rate was left unchanged as they plan to maintain rates at this level “until the disinflationary process consolidates and inflation expectations anchor around its targets”. The BCB still has lower inflation forecasts than the market, expecting 5.8% for 2023 and 3.6% for 2024 compared with 6.1% and 4.2%, respectively (Focus survey).
The Czech National Bank also kept policy rates unchanged and maintained its policy of smoothing volatility in the exchange rate. The disinflationary benefits of gradual currency appreciation are clearly positive, and so they seem comfortable continuing to make their currency attractive to yield-seeking investors for now. The updated CNB forecasts have higher inflation in 2023 and stronger growth in 2023 and 2024.
Next week we have Chile and Poland. Both central banks are on hold, with the Chilean Central Bank beginning the process of unwinding their stock of FX forward contracts, which were used in addition to reserve drawdowns to stabilise the currency in 2022. This means that they will be effectively purchasing USD50mm per day. That’s not a large portion of the daily turnover, but it’s a consistent flow which at around USD1bn a month, is approximately half the size of the monthly trade balance in recent months.
In Poland, as in much of the world, policymakers must wait to gain confidence over the process of disinflation before they can consider any easing measures. This week we saw the second consecutive fall in manufacturing PMI, which failed to break 50 in its latest upswing. Looking at details of the last meeting there were a couple of MPC members wanting a further hike of 25bps in March, and one particularly enthusiastic Hawk, Joanna Tyrowicz, proposing a 1% hike.
Monitors
Correlation
The unusual positive correlation between much of USD/ASIA and EURUSD remains. The nature of the recent sideways chop has increased the level of idiosyncrasy among EM pairs. Looking at the correlation between key EMFX themes and prices is perhaps more informative at this juncture.
Here we can see that example funders, USDCNH and USDKRW are strongly positively correlated with the carry, RR themes. We can see the evolution as HUF and IDR become notable carry currencies this year. We can see the increasingly positive correlation of EURUSD with Carry and RR this year. This partly reflects the rotation away from the US towards the EU and China as growth engines in 2023.
Trend
As we can see, in the 3month we have Carry FX trending stronger and the funders trending weaker. The 1-month trends are diminished by this phase of chop we’ve hit. Too long in this phase will start to erode the case for holding this carry strategy.
Carry
I would have expected more of a pick-up in vol associated with the upcoming debt ceiling, however, the low level of realised vol in much of EM FX continues to have a depressive effect.
Signing off
Please share the note with anyone you feel might enjoy it. As always, any feedback and engagement would be very welcome.
In the meantime, if you’re trading, be disciplined and be lucky,
Stephen