MNI ANALYSIS: Asian FX Getting Ahead Of The Fundamentals

--Asia Forex Gains 'Increasingly Running On Fumes'

By Stuart Allsopp

     SINGAPORE (MNI) - Asian FX continues to rally despite the continued

narrowing of interest rate spreads between most Asian countries and the U.S. In

total return terms, the Asian dollar index is trading at an all-time high, even

as the average interest rate differentials fall to their lowest levels since

before the Global Financial Crisis. Recent gains are not justified by the

fundamentals, suggesting cautions is warranted, particularly in the event of a

decline in US stocks.

     To assess whether this trend for Asian FX is sustainable, it must first be

determined whether it is being driven by fundamental forces. Emerging market FX

gains can be justified in the face of declining interest rate differentials if

inflation differentials are declining, default risk is declining, or currencies

are recovering from undervalued levels. None of these appear to explain recent

Asian FX gains.

     --LOWER INFLATION NOT EXPLANATION

     Looking at differentials, there has been a steady decline in Asian

inflation over the past year while U.S. inflation has risen mildly. But even

with inflation differentials narrowing, real interest rates have still moved in

the U.S.'s favour across the board over the past year as the rise in U.S.

interest rates relative to Asian interest rates has been larger than the rise in

inflation.

     --DEFAULT RISK

     With real interest rate differentials not explaining Asian FX gains,

another possibility is that declining default risk among Asian currencies has

improved their attractiveness. If we look at Asian-U.S. real interest rate

differentials adjusted for 5-year credit default swaps, the risk-adjusted real

interest rate spread has moved slightly less in the dollar's favour. 

     However, the fall in Asian CDS spreads has been minimal compared to the

much larger move in real interest rate spreads.

     --NO LONGER CHEAP

     It is also no longer the case that Asian currencies are recovering from

undervalued levels. Most Asian currencies are trading above their long-term

averages in real effective terms, suggesting that they are far from cheap,

having recovered strongly from their late-2016 lows.

     --THREE SCENARIOS

     With the fundamentals not explaining recent Asian FX strength, there are

three potential scenarios for the region's currencies. 

     Firstly, weakness ensues in line with the deterioration in risk-adjusted

real yield spreads seen over recent months. 

     Secondly, the fundamental picture moves in favour of Asian FX as the weak

dollar is discounting a surge in US inflation or a policy mistake by the Fed, or

Asian central banks tighten policy significantly. 

     Thirdly, the strength continues regardless of the fundamentals and then

results in a 2008 style snap back.

     --LOWER US STOCKS A THREAT

     Continued Asian FX strength certainly sets up for a potentially painful

reversal, particularly if U.S. stocks begin to decline more sharply. A decline

in US stocks would likely have two negative implications for Asian FX. It would

put upside pressure on US real interest rates as inflation expectations would

likely fall much faster than any decline in borrowing costs as was the case

during the last major Asian FX sell-off during the Global Financial Crisis. 

     Additionally, it would likely create tightness in global credit markets

causing Asian CDS spreads to widen, further undermining risk-adjusted real

yields across the region.

     Global credit spreads have to date taken falling US stocks in their stride,

but if history is any guide sharper declines on Wall Street would be highly

likely to cause U.S. junk bond spreads to widen, triggering similar moves across

emerging market dollar debt. For now, the rally in Asian FX continues, but it is

increasingly running on fumes.

--MNI London Bureau; tel: +44 203-586-2225; email: les.commons@marketnews.com

--MNI London Bureau; +44 203-586-2226; email: jamie.satchithanantham@marketnews.com

[TOPICS: M$A$$$,M$$FI$,MN$FI$,MN$FX$]