EM FX: Where to hide? – Deutsche Bank

Gautam Kalani, Strategist at Deutsche Bank, assess the exposure of EM currencies to three key risk factors in the post-election world: higher US real rates, increased trade protectionism and greater US rates volatility.

Key Quotes

“From the early post-election price action, it is clear that EM FX has followed real rates, and depreciated with the spike in US long-end real rates.”

“Despite the uncertainty on the overall direction for broad EM FX, we can still shed light on the relative exposures of currencies to the various risks that are potentially on the horizon. The two key risks, are further increases in US real rates and increased trade protectionism triggered by the US. While the latter is a more long-term risk and is subject to potential watering down vs. pre-election rhetoric, we believe it is important to take it into account given that the market could start pricing it well in advance, particularly in a risk-off scenario. A third risk, particularly for carry currencies, comes from a spike in US rates volatility. Assessing the exposure of EM currencies to these risks highlights attractive RV opportunities that can be implemented, even as we wait for clarity on the direction of EM FX more broadly.”

“1) EM FX betas to US real rates: Given the importance of US rates as a driver of EM FX, this is a good place to start to assess which currencies are exposed, beyond the knee-jerk selloff in EM FX we saw over the past few days. The right chart below shows that MXN, ZAR and BRL have by far the highest betas to US real rates. Meanwhile, the likes of IDR, INR and RUB have much less exposure.”  

“2) Direct trade linkages to the US: If Trump does embark on a large-scale protectionist agenda on the trade front, as indicated in his campaign rhetoric, then those EMs which rely more on exports to the US have greater exposure. On this metric, MXN clearly has the most exposure, with exports to the US accounting for 80% of total exports and nearly 30% of GDP. COP also has significant trade links with the US. Elsewhere, Asia has particularly large trade links with the US and exports make up a greater share of GDP for most countries in the region – SGD, MYR, THB and KRW are very exposed. Further, Trump has been particularly hawkish in his rhetoric around trade with China, which adds further downside risk to Asian economies’ trade and growth outlook. EMEA, barring ILS, is relatively insulated. RUB again has very limited exposure to the US through the trade channel.”  

“3) EM FX betas to US rates volatility: The third channel through which EM FX is exposed is via a pick-up in US rates volatility. As the left chart below shows, US rates vol spiked post the election (along with US rates), with EM FX tracking this move. US rates vol has been an important driver of carry performance this year. Therefore, if vol continues to pick up, along with a spike in US real rates, this is a very difficult environment for carry. Assessing the betas to rates volatility, we see that the ordering closely matches that of the betas to US real rates – MXN, BRL, COP and ZAR are again the most exposed while INR and IDR are relatively safe.”