MNI ANALYSIS: EM FX Underperformance Nearing An End

--EURCNH Will Play A Major Role But EM Carry To Dominate

By Stuart Allsopp

     LONDON (MNI) - Weakness in EM FX relative to DM FX appears to have

overshot, suggesting relative outperformance ahead for emerging currencies,

particularly in total return terms. Much will depend on the performance of the

euro and the yuan, however, with EURCNH currently threatening to break into a

higher range.

     For the time being, emerging currencies remain under pressure, despite some

recovery in the majors relative to the dollar. The chart below shows the JP

Morgan EM FX Index versus the U.S. Dollar Index since September 2000, with the

decline since April dwarfing those seen during the global financial crisis and

the 2015 China devaluation. Asian FX has performed somewhere between the

categories, recently hitting a new high versus the EM FX basket but a multi-year

low versus the DXY.

     PANIC POINTS TO TRADEABLE LOW

     After such a large selloff, EM FX now appears to be in the process of

bottoming out. The panic experienced in the Turkish lira and South African rand

this month strongly hint at intermediate lows. The rise in short-term interest

rates in these countries, as well as in Brazil, Russia, and Indonesia, where

rates have risen much faster than inflation, is a major supportive factor for

riskier EM FX.

     Similarly, the level of fear among EM dollar debt investors remains

elevated with the EM sovereign spread rising to a 2.5-year high earlier this

month. The spread is above that of U.S. high yield corporate bonds for the first

time since 2006, suggesting a high degree of risk aversion towards EM assets,

which has previously tended to be positive for future returns.

     EURCNH WILL BE KEY

     The big uncertainty is what happens to the yuan given its importance in the

EM FX basket, and to the euro, given its weighting in the DXY. EURCNH is testing

the 8.00 level. A close above this would send the pair into a higher trading

range, targeting mid-2014 highs of around 8.70. Such a move would likely imply

continued softness in the Chinese economy, with negative implications for EM FX

more broadly, ensuring continued underperformance. That said, we continue to see

EM outperformance in total return terms given the hugely favourable carry

differentials.

--MNI Singapore Bureau; +65 8233 2326; email: Asia-Editor@marketnews.com

--MNI London Bureau; +44208-865-3829; email: Jason.Webb@marketnews.com