EMD Relative weekly notes
Week Ending May 11, 2018
In a brief three and a half week period beginning on April 16, the US dollar shot up 4.0%, swifty taking emerging market sentiment in the opposite direction. EM currencies fell and a number of countries like Indonesia and Argentina spent foreign reserves to help stabilize the fall.
Such a swift rise brings to mind the 2014-2015 period when the dollar skyrocketed over 25% from mid-2014 to the beginning of 2016. The local currency EMD index fell 5.7% in 2014 and 15% in 2015—so caution definitely seems warranted.
However, over the past two days the dollar rally has re-traced as softer-than-expected inflation numbers have eased concerns about a more hawkish Fed. In our view, more modest growth expectations ex-US has stalled rates normalization virtually everywhere, leaving the Fed alone in tightening. That divergence—not simply the fact that the Fed was hiking—seems to us to explain the dollar's resurgence since mid-April.
We cannot, of course, know whether the cooling of the dollar late this week will last. That will be key, since an extended period of dollar strength should vacuum liquidity from EM, weaken credit fundamentals and lead to rate hikes, as history has shown. It is far too early to suggest that path is certain or even likely. For those inclined to EM bearishness, we remind you that the 2016-2017 period demonstrated that when the dollar's path switches, those negative effects can be quickly forgotten as reserves rise and local rates fall—and asset prices potentially rise swiftly.
What is different in this cycle is, in our view, that investors are not compensated for taking currency risk in EM. The chart below shows a five-year view of dollar and local yield spreads. Note that, historically, there is around a 100 basis point pick-up versus dollar debt for local investors, an advantage that has completely evaporated.
During the period of the dollar's recent rise, absolute yields on the dollar EMD sovereign index widened by over 40 basis points and spreads over treasuries widened even more. When the dollar's rise began in mid-2014, yields were just a touch over 5%, yet total dollar returns for the 2014-2015 period were 8.7%. With a higher starting yield cushion, we think dollar EMD debt in particular seems to offer attractive return potential given future dollar path uncertainty.