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Emerging Market Currency Correlations Break Down

A picture is truly worth a thousand words. [That probably means I should stop writing lengthy blog posts and instead stick to posting charts and other graphics, but that’s a different story…] Take a look at the chart below, which shows a handful of emerging market (“EM”) currencies, all paired against the US dollar. At this time last year, you can see that all of the pairs were basically rising and falling in tandem. One year later, the disparity between the best and worst performers is already significant. In this post, I want to offer an explanation as to why this is the case, and what we can expect going forward.

In the immediate wake of the credit crisis, I think that investors were somewhat unwilling to make concentrated bets on specific market sectors and specific assets, as part of a new framework for managing risk. To the extent that they wanted exposure to emerging markets, then, they would achieve this through buying broad-based indexes and baskets of currencies. As a result of this indiscriminate investing, prices for emerging market stocks, bonds, currencies, and other assets all rose simultaneously, which rarely happens.

Around November of last year, that started to change. The currency wars were in full swing, inflation was rising, and there were doubts over whether EM central banks would have the stomach to tighten monetary policy, lest it increase the appreciation pressures on their respective currencies. EM stock and bond markets sputtered, and EM currencies dropped across the board. Shortly thereafter, I posted Emerging Market Currencies Still Have Room to Rise, and currencies resumed their upward march. It wasn’t until recently, however, that bond and stock prices followed suit.

What changed? In a nutshell, emerging market central banks have gotten serious about tackling inflation. That’s not to say that they raised interest rates and accepted currency appreciation as an inevitable byproduct. On the contrary, they have adopted so-called macroprudential measures (quickly becoming one of the buzzwords of 2011!), with the goal of heading off inflation without influencing broader economic growth. Most EM central banks have sought to achieve this by raising their required reserve ratios (see chart above), limiting the amount of money that banks can lend out. In this way, they sought to curtail access to credit and limit growth in the money supply without inviting a flood of yield-seeking investors from abroad. Other central banks have gone ahead and hiked interest rates (namely Brazil), but have used taxes and other types of capital controls to discourage speculators.

You can see from the chart of the JP Morgan Emerging Market Bond Index (EMBI+) below that EM bond markets have rallied, which is the opposite of what you would normally expect from a tightening of monetary policy. However, since EM central banks have thus far implemented tightening without directly influencing interest rates, bond yields haven’t risen as you might expect. In addition, whereas sovereign credit ratings are falling in the G7 as a result of weak fiscal and economic outlooks, ratings are actually being raised for the developing world. As a result, EM yields are falling, and the EMBI+ spread to US Treasury securities is currently under 3 percentage points.

The primary impetus for buying emerging markets continues to come from interest rate differentials. Given that interest rates remain low (on both an historical and inflation-adjusted basis), however, it’s unclear whether support for EM currencies will remain in place, or is even justified. Furthermore, I wonder if demand isn’t being driven more by dollar weakness than by EM strength. If you re-cast the chart above relative to the euro, the performance of EM currencies is much less impressive, and in some cases, negative. This trend is likely to continue, as Ben Bernanke’s recent press conference confirmed that the Fed isn’t really close to hiking interest rates.

Ultimately, the outlook for EM currencies is tied closely to the outlook for inflation. If raising the required reserve ratios is enough to head off inflation (and other forces, such as rising commodity prices, abate), then EM central banks can probably avoid raising interest rates. In that case, you can probably expect a correction in forex markets, which will be amplified by rate hikes in the G7. On the other hand, if inflation continues to rise, broad EM interest rate hikes will become necessary, and the floodgates will have been opened to carry traders.Either way, the gap between the high-yielding currencies and the low-yielding ones will continue to widen. In answering the question that I posed above, I expect that regardless of what happens, investors will only become more discriminate. EM central banks are diverging in their conduct of monetary policy, and it no longer makes sense to treat all EM currencies as one homogeneous unit.

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Russian Ruble Undervalued According to Central Bank

In the midst of the currency war controversy, there is one emerging market country that continues to insist that its currency is undervalued: Russia. While being a member of the illustrious group of BRIC (Brazil / Russia / India / China) countries would seem to guarantee an appreciating currency, there are strong forces weighing on the Ruble. In other words, that it remains weak is not due to investor oversight.
Ruble Dollar Chart 2006-2010

If you view the performance of the Russian Ruble over the last few years, it’s clear that it never recovered from the rapid depreciation that took place during the height of the credit crisis. Given that nearly every other emerging market currency is either closing in on or has already breached its pre-credit crisis level, there must be something holding down the Ruble.

That something happens to be a sizable current account deficit. Unlike with other emerging markets, capital is actually flowing out of Russia. There are a few reasons for this: first of all, much of Russia’s debt is denominated in foreign currency, as a consequence of its massive default in 1998. Specifically, “The private sector has about $16 billion in foreign debt, including interest-rate payments, due this month [December], double the $8 billion of redemptions in October and November.” This means that every month, Russian companies must scramble to exchange Rubles for Dollars and Euros.

Next, the real returns of investing in Russia are currently negative. Russia’s Central Bank (Bank Rossii) continues to maintain the benchmark refinancing rate at a record-low 7.75%, and the 10-year yield on Russian bonds is even lower, at ~5%. This would seem to compare favorably with the 2.75% yield on comparable US Treasury Securities until you account for inflation, which is projected to top 8% for the year. While Ruble-denominated bonds pay a higher interest rate (7.75%), they also carry higher risk. For that reason, Russian yields and credit default swap spreads (which insure against default) are much higher in Russia than in other BRIC countries.

JPMorgan EMBI Russia Blended Yield Chart 2010

Meanwhile, Russian companies are taking advantage of low borrowing rates to engage in a reverse carry trade and invest in western countries: “Russian companies have announced $27 billion of foreign purchases this quarter, the most since the third quarter of 2008 and triple the amount in the last three-month period.” Finally, the reemergence of the EU fiscal crisis, combined with the skirmish in Korea has spurred a decrease in risk appetite. As one analyst summarized, “The whole of the emerging markets are on the back-foot at the moment and the ruble is no exception…it’s definitely risk off at the moment.”

As a result, Bank Rossii finds itself in a somewhat unique position among Central Banks of having to try to prop up its currency. Technically, the Rouble is pegged to a basket (consisting of 55% Dollars and 45% Euros), but pressure on it has been so intense that the range in which it is permitted to trade has been adjusted downward five times since the middle of October. To prevent it from declining further, Bank Rossii has been dipping into its $450 Billion stock of forex reserves, and selling foreign currency at the rate of $150 million per day. It insists that it will “allow” the Rouble to appreciate in 2011 in order to fight inflation, but that obviously depends on whether the current account shifts back to surplus.

What do investors think? According to a Bloomberg survey of currency analyst, “The Ruble will strengthen 4 percent versus the basket by the end of the first quarter of 2011. On the other hand, “Options traders are still bearish on the ruble with the currency’s one-week risk reversal rate — the premium of put options over calls — at 1.25 percent for the tenth straight day, from 0.5 percent at the end of October.” Non-deliverable forward contracts, meanwhile, reflect a weaker Ruble three months from now.

If the Bank Rosii fulfills analysts’ expectations and hikes rates in March, it will be step towards reinvigorating investor interest in Russia. More importantly, however, is that inflation is brought under control. Until that happens, the Ruble will remain the main standout in a sea of emerging market currencies that otherwise continues to outperform.

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Hungarian Forint Touches Record Low

Anyone who had bought emerging market currency(s) at the peak of the credit crisis in 2008 would have earned double digit annualized returns in the two years that have passed since then. There are only a handful of exceptions to this rule, and the most prominent one that I can think of is the Hungarian Forint. If you had bought the Hungarian Forint against the Swiss Franc (the base currency that most traders in the Forint look at, for reasons that I will explain below) in the fall of 2008, you would incur a loss of a 63% if you sold today. The Forint is down 11% in the last month alone. These are the kinds of numbers one might associates with mortgage-backed securities and credit default swaps, not currencies!

Swiss Franc CHF Hungarian Forint HUF 2010

So why is the Forint in the doghouse? Ironically, the answer is connected to mortgages. During the inflation of the housing bubble, Hungarians preferred to borrow in Swiss Francs, because interest rates were significantly lower than domestic Hungarian rates. This was not a mere trend; it was a full-blown phenomenon: “About 5.4 trillion forint($24.1 billion), or two-thirds of Hungary’s overall household credit, is denominated in foreign currencies. Of that, 82 percent is in Swiss francs, according to central bank data.” When the housing and credit markets were stable, noone bothered to examine currency risk. Given how much the Forint has fallen against the Franc, you can bet they are now.

As if the decline in housing prices wasn’t bad enough, consider that Hungarians that borrowed in Swiss Francs have now seen their mortgage payments/balances increase by more than 50%, depending on when they took out their loans. It goes without saying that even under the best of circumstances, it would be difficult to find the wherewithal – let alone the motivation – to repay such a loan. When you throw an economic recession into the mix, the prospects for repayment become even more bleak. As the Hungarian Forint has depreciated, loan defaults have risen, further stoking the Forint’s depreciation and loan defaults.

Alas, the Hungarian government’s program for solving this crisis is to punish the banks, both by allowing borrowers to delay repayment and by levying a massive tax – the highest on the EU – on all banks. While this might be helpful for bringing down the country’s budget deficit to the 3% mandated by the EU, it probably won’t do much for the economy. Speaking of the budget deficit, it has prompted S&P to warn of a possible cut in Hungary’s sovereign credit rating to junk-status.

Hungary’s cause hasn’t been helped by the breakdown of talks with the EU and IMF that would have supplied it with emergency funding. As if it wasn’t obvious from the Forint’s decline, investors are beginning to fear the worst and are slowly turning away from Hungary. The country’s benchmark stock market index has fallen 4% over the last six months. Meanwhile, foreign lenders are starting to balk at buying Hungarian debt without some kind of EU/IMF backstop, much like the one that was afforded to Greece: “Auction saleshave been a barometer of investor confidence in the country. On Sept. 2, Hungary sold 35 billion forint of 12-month Treasury bills, 15 billion forint less than planned, after receiving bids for 63.4 billion forint of the bills. Five days later, it sold 60 billion forint of three-month Treasury bills, 10 billion forint more than planned.”

At this point, all eyes are on the Hungarian government to simultaneously boost the economy and repair its budget deficit: “The rating agenciesare taking the same line as the markets and giving the government until local elections in October the benefit of the doubt, but if they don’t see then either a recommitment to the IMF program, or real concrete measures I think they move to cut the rating to junk.” If that were to happen, the self-fulfilling downward spiral in the Forint would probably continue unabated.

It makes you wonder: if the Greek Drachma were still around, how closely would it resemble the Forint?

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Brazil is Booming, but Real is In Trouble

Generally speaking, investors are bullish about Brazil. The emerging market superstar emerged from the credit crisis essentially unscathed, and some believe that “Brazil will be the world’s fifth-biggest power by the next decade.” This year, the IMF is forecasting GDP growth of 5.5%, while the Central Bank of Brazil is projecting 6%.

But this post isn’t about the economy of Brazil. It’s about its currency, the Real. To put it mildly, investor sentiment surrounding the Real is slightly less rosy. The 30% appreciation (from trough to peak) against the Dollar has come to an end. “ ‘Buyers are exhausted. The real has been a pretty crowded trade and what’s happening is a lot of these long-term crowded positions are getting sold,’ ” summarized one money manager.

There are a handful of issues. First is the technical concern that the Real simply rose too far, too fast. “The currency’s weekly TD Sequential indicator suggests an almost yearlong rally against the dollar ended in October, while the moving average convergence/divergence, or MACD, chart shows the real is likely to weaken.  ‘A new trend has started and it’s strongly bearish.’ ” This notion is supported by an explosion in the so-called risk-reversal rate on the Real, in favor of options that give investors the right to sell. In fact, “insurance” on the Real is now the most expensive of any emerging market currency.

Investors are also nervous about the sovereign debt crisis in the EU, and are responding by temporarily moving funds back to safe haven currencies. “ ‘We’re seeing a lot of declines on top of concerns about Greece and Europe. Flows will come back to Brazil when you have signs of stability out there, and it doesn’t look like that will happen in the short term.’ ” Of course, this is also impacting the carry trade, as investors re-examine their models governing the trade-off between risk and return.

To be fair, increased risk could be accompanied by increased returns. Even withstanding a poor performance by the Real, itself, the benchmark Brazilian Selic rate stands at a healthy 9.5%. In all likelihood, it will be hiked past 10% next month, and to 11% by the end of the year. On the flipside, inflation is also surging (5.5% at last count). From the standpoint of investors, this is not really a concern, since there is no intention of using invested capital for consumption purposes. In fact, it could even be seen as positive, insofar as it will force the Central Bank of Brazil to continue to be aggressive in conducting monetary policy.

There seems to be a slight dichotomy between the data and the markets. On the one hand, there is plenty for investors to be excited about when looking at Brazil. On the other hand, the reality is that there just isn’t much excitement at the moment being channeled towards the Real. If interest rates continue to rise, and the debt crisis in Euro can achieve some kind of (stopgap) resolution, perhaps this will change.

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