EMFX Macro - Brighter horizons for EM
Image from DALL-E.
Since my last note, we’ve seen significant developments across the macro landscape. The Fed kicked off its easing cycle in September with an aggressive 50bps cut, which prompted the market to price in a further 75bps over the next two meetings, alongside more than 100bps for 2025. At the same time, US data surprises have been steadily climbing since July, with inflation surprises moving sideways - anointing the more constructive view on the disinflation process. Meanwhile, in China, the government has announced a raft of stimulus measures.
In this note I’m going to discuss the following:
Recent moves in EMFX
Where we stand in my framework
China stimulus.
FX Carry - opportunities and challenges.
Brazil - if not now then when?
External vs fiscal - still diverging.
Recent moves in EMFX
Let’s look once more at how EM FX has moved on a NEER basis—stripping out some of the USD move. Here, you can see some outsized moves from the low-yielders, notably MYR and THB. The magnitude of these moves took me by surprise. It’s clear that a substantial carry trade had built up across a range of economic agents throughout the US hiking cycle. The unwind was violent, with expectations of a reversal of USD hoarding by local corporates in Asia triggering heavily skewed demand. The big winner outside Asia has been ZAR, with lower US rates dovetailing well with a more centrist approach emerging from the new coalition government in South Africa. Meanwhile, many higher-yielding EMs continue to suffer from local political noise and deteriorating fiscal expectations, including Mexico, Brazil, Colombia, and Hungary.
Where we stand in my framework
The recent US policy repricing provides a tailwind for EM assets. Recent US growth data that challenges the scale of this repricing also provides the stability that risk assets crave. Importantly, the overall direction of policy remains supportive and represents a positive shift for EMFX and broader EM assets. Historically, US easing has supported capital flows into higher-yielding emerging markets. My base case is that this will be a shallow easing cycle, so it’s important not to get carried away by this shift alone.
In combination with US easing, recent stimulus measures out of China—while less impactful on their own—add further momentum to the EM story. China’s policy actions can stabilise sentiment around China-linked assets and currencies. The interplay of these two factors—the Fed’s easing and China’s stimulus—creates a more favourable environment for EMFX, easing the “Dragon-Greenback squeeze.”
China Stimulus
While I remain sceptical over the medium-term, recent developments in China's stimulus approach mark a decisive break from its previously gradual tactics, signalling a determined effort from the top to stabilise the economy. The combination of rate cuts, significant fiscal measures, and bond issuance reflects a "whatever it takes" mindset aimed at addressing multiple challenges. Notably, the increased bond issuance is expected to enable around 1 trillion RMB in additional fiscal stimulus, directed towards key sectors such as consumer durables, housing, and services like elderly care and healthcare.
The PBoC has also introduced new lending facilities, akin to the US TARF programme, designed to support financial institutions and companies engaged in share buybacks. This unprecedented move could establish a sustained floor for asset prices, particularly in equities. However, while initial optimism has buoyed markets, the real test will be whether these policies are effectively implemented to support a broader economic recovery.
In terms of currency, there is optimism for the RMB, which could benefit from renewed economic activity and potential foreign inflows into Chinese equities. However, the looming US election and the potential for a Trump victory with tariffs will soon dominate the narrative.
I won’t say too much about the US election—the polls are painfully close. My only view is that if one can find good leverage (and I think you can) in USDCNH call option structures, these should play a role in a portfolio. The limited historical precedent points to the Chinese authorities allowing significant currency depreciation to counter tariffs.
FX Carry - opportunities and challenges
FX carry remains a challenging theme in the current environment. On the one hand, the substantial drawdown suggests we could be at a ripe moment to buy the dip, following historical patterns. On the other hand, many of the currencies that would typically feature on the long side of carry trades come with notable risks. On the short side, Asian currencies are appealing given the potential for a retracement in US rates. This is complicated by the recent China stimulus and the tail risk of a material unwinding of hoarded USD in several countries. Below, I look at carry versus a simple measure of value (deviation from 10-year REER).
Among the standout carry currencies, the three usual suspects—COP, MXN, and BRL—remain prominent, though each faces challenges.
BRL looks compelling on most metrics but fiscal risks have overwhelmed the positives so far this year.
COP is particularly vulnerable to an acceleration of policy easing, which could rapidly reduce real rates and put pressure on the currency, especially given Colombia’s weak fiscal outlook.
MXN has suffered from domestic growth deterioration and governance concerns. Stronger US growth expectations are a positive.
Adjusting for volatility (I use tail hedging costs) provides a more nuanced view. Here, our three Latin American carry friends—BRL, COP, and MXN—slip down the list as their vol-adjusted returns become less compelling. INR stands out as a favourable option, although the other top candidates appear expensive.
Two carry currencies that have recently performed are ZAR and IDR, both benefiting from increased demand for their bond markets. These remain strong picks but approach them with caution as short-term outperformance brings positioning risks.
It’s worth mentioning CEE currencies in light of these charts. They have periodically been profitable carry longs over the past few years, but at present, they look dangerously overvalued, and I would be very cautious.
TRY remains the stand-out carry trade in EM and has been performing well. I am forced to exclude it from many of my metrics given the extremes it occupies. As a managed currency - for now - it exhibits extremely compelling carry-to-vol dynamics, although real appreciation this year has made it look expensive. Recent poor inflation data seems likely to defer easing and to my mind reinforces the value of a stable currency. If policymakers retain their orthodox approach, then the TRY carry trade will have legs.
BRL - if not now then when?
Following on from the above, BRL screens compelling on several other metrics we’ve discussed before. The BCB has been pushed into a hiking cycle by a combination of currency underperformance and rising inflation expectations. The latter is partly due to an economy growing above potential alongside a tight labour market, both impacted by scepticism over the fiscal outlook. Brazil has one of the largest net deficits among the countries I look at here. While expectations haven’t deteriorated rapidly, a lack of confidence in the government’s ability to address these concerns weighs on sentiment. Moreover, there is a highly polarised political environment, and domestic market participants are heavily skewed against Lula.
Nonetheless, much of this should be priced in. Given the current negative sentiment, there is likely an asymmetric outcome to any new fiscal developments. To my mind, the hiking cycle is a clear demonstration to the government of the negative consequences of its current stance. Lula knows the country needs lower rates, and perhaps he can be persuaded to have a “come to Jesus” moment to make that more likely. As for the positives, the start of the hiking cycle has caused ex-ante real rates to reprice higher, placing them top of my list.
Currencies usually respond well to growth upgrades, and Brazil leads my list on consensus growth forecast changes for 2024.
So, we have rising ex-ante real rates, growth upgrades, the strongest combination of carry versus valuation, and a goldilocks backdrop, along with a China stimulus. If BRL trades poorly with these dynamics on its side, then the fiscal story must be deteriorating even further.
External vs fiscal - still diverging.
In my last note, I laid out my framework, highlighting the post-pandemic trend of weaker fiscal positions and stronger external positions. The weaker fiscal balances made sense given the higher debt levels and rates, while on the external side, weaker growth and depreciated currencies explained some of the phenomenon. This is an ex-post story, but what surprises me is that these dynamics persist despite easing and currency appreciation. A look at 2025 forecast revisions shows both trends.
As we can see there has been a continuation of the trend for improving external positions, with few exceptions.
Fiscal revisions skew heavily negative, led by Poland. It’s worth noting that beleaguered Brazil is far from an outlier in terms of deterioration, although high rates make for larger absolute deficits than most.
Larger fiscal deficits make currencies more vulnerable. Central banks aiming for stable exchange rates will have to offer higher real rates to offset these risks. Markets will punish countries with poor fiscal dynamics that ease rates too aggressively, even in a goldilocks environment.
Signing off…
Thank you for your time and attention. Please feel free to reach out with any feedback. As mentioned earlier, these notes will be infrequent but I look forward to checking in periodically.
As always, if you’re trading, be disciplined and be lucky.
Stephen
Disclaimer
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