EM Currency Stability Set to Continue Near Term

  • Emerging markets are experiencing steady capital inflows and currency appreciation on a broad basis, with a few exceptions.
  • Fears of rapid US interest rate hikes due to sharp increases in economic growth and inflation expectations have subsided due to political dysfunction in the US once again. The new Republican led government has been unable to pass major reforms in healthcare, taxation, regulation, or infrastructure.
  • A period of EM stability is set to continue other than politically inspired turbulence in the Middle East over Qatar and global energy oversupply risk.
  • Value can still be found in broad EM FX vs. USD, CHF, and JPY. Expect supportive trend continuation in CNY, ILS, MXN, ZAR, RUB, and COP.
  • Spain’s troubled Banco Popular was acquired by Santander in what is being viewed as a successful ECB assisted bailout. This has relieved some near term banking system stress in the European periphery. Although Banco Popular common equity and junior debt holders were wiped out, senior debt holders were spared. This reinforces what is theoretically supposed to happen with various investor risk segments in the capital structure, although central bank involvement is not ideal.

em debt in usd strong flows 060617

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USD Soft Patch to Set the Stage for Another Grind Higher in Asset Prices and Interest Rates

  • Bullish USD sentiment clearly became overly reliant on the Trump Administration’s desired agenda of tax cuts, deregulation, and infrastructure.
  • Due to the host of potential political scandals plaguing the Administration, as well as general political dysfunction in the US Congress, expectations of a pro-growth agenda being enacted this year have been significantly muted, though not completely discounted by Assist FX.
  • Assist FX still sees passage of a lighter version of market-friendly reforms in 4Q2017/1Q2018 limping past the finish line in what is becoming a non-consensus call. Sparring blocs within the Republican party will increase cooperation as political viability becomes increasingly threatened for the 2018 midterm elections.
  • In the near term, USD will struggle to stage sustainable rallies as political uncertainty takes its toll.
  • As financial asset prices in equities, real estate, and alternatives continue to inflate further into historically stretched valuation territory, it will place pressure on the Fed to remain on track for gradual rate hikes approximately once per quarter.
  • Long duration USTs will be pressured by lower real yields, lifting rates at the long end of the curve. This will contribute to moderate firming in USD in the medium term 3-6 month outlook.
  • Top risks to this view include a pronounced spillover effect from China’s debt deleveraging efforts resulting in global financial market instability, as well as any number of potential Trump Administration scandals escalating to such severity that the blow-back shifts the political landscape in favor of left leaning populists for 2018 and beyond. While these risks are currently underappreciated by markets, they are not our base case.