The recent jitters in emerging markets (EM) have led to marked sell-offs in the currencies of affected countries but there were only minor repercussions in the G10 sphere. CHF and JPY have gained but notably EUR/USD is little changed in recent weeks. We think the key reason is trust in the Fed’s willingness to adjust policy if necessary and in positioning. We maintain the view that provided no escalation in the EM unease is seen, EUR/USD will head lower as 2014 progresses.
Lack of G10 repercussions to EM sell-off
The series of local events that has triggered the EM sell-off has come at a time when Chinese growth is decelerating, commodity prices are under pressure and the Fed is starting to rein in monetary easing. Thus, the heavy currency weakening witnessed recently would likely have been brought about eventually even in the absence of political unrest. As our EM economists argue in Flash Comment: EM turmoil - it aint over till the Chinese lady sings (29 January 2014), the negative consequences for growth that rate hikes led to, notably in India, Turkey and South Africa, will gradually come into focus. Until we get more transparency on the outlook for China, caution is still very much warranted in relation to EM currencies.
Where does this leave the G10 currencies? While most have sold off against USD since the New Year – except JPY – more pronounced USD strength could probably have been expected in this type of environment. Notably, yesterday’s FOMC meeting contained few surprises and the QE tapering process seems on autopilot as Janet Yellen takes over from Ben Bernanke as the Fed’s head. In our view, it will take significant changes to the outlook for the unofficial tapering plan of cutting the programme by USD10bn per meeting for the rest for the year to be deviated from. Still, USD did not gain much.
In the Fed we trust
We think the key reason for this lack of USD strength is that markets trust that the Fed would react if things went awry (even if the FOMC notably did not specifically comment on the risks from recent EM unrest): Yellen is a trusted partner when it comes to central-bank aid in case of financial stress. In a nutshell, should EM issues endanger the global recovery, the Fed would be in a position to halt its tapering process. The main risk to such trust in Fed responsiveness is that the US economy decouples from the rest of the world, which could make it more difficult for the Fed to react to issues elsewhere.
At the same time, in the past month, the euro been supported by tight eurozone liquidity; although EONIA fixings have now come down to more normal levels (and notably are now below the refi rate), the still elevated levels of EUR-USD cross currency basis swaps and a narrowing of peripheral spreads remain supportive of EUR. Moreover, an ECB reaction to continued EM turmoil is much less likely than one from the Fed. We still think the ECB will deliver more easing in coming months but this will most likely be in response to lower-than-projected inflation prints.
To Read the Entire Report Please Click on the pdf File Below