FX Dashboard: Taper Tantrum vs Current Reflationary Scare – Part 1

As we discussed last week, the US dollar has stayed relatively calm despite the volatility in global financial markets driven by the sharp rise in US long-end yields. Indeed, the dollar index (DXY) was flat this morning at 91.1, still within the 89.5-91.5 range that it has maintained since mid-December.

EM currencies though were weaker on average by 0.2%, led by the 1.1% drop in the Korean won (KRW), which was under pressure as local yields hit a 2-year high. Besides the won, the Turkish lira (TRY), the Brazilian real (BRL), and the Colombian peso (COP) depreciated between 0.6-0.7% each.

In our recent notes (see, for example, FX Dashboard: EM FX Volatility Remains Low), we have been making the point that while EM currencies have weakened as US yields have risen 50 bp since the start of the year, the sell-off has been relatively contained. To emphasize this further, we compare the performance of EM currencies during the so-called Taper tantrum of 2013 with the current sell-off.

We chose Taper Tantrum as the episode to compare because of its similarities with the current reflationary scare. To recap, in the spring of 2013, financial markets went into a reflationary panic when the Fed announced that they may start tapering its QE-related bond purchases sometime in the future. Starting in May 2013, the US 10y yield went from around 1.7% to 2.7% in just over 2 months. The current reflationary scare has not been quite as ravaging, but the US 10y yield has still gone up over 50 bp in 2 months.

In the chart below, we regress EM currencies against US yields, both in the current episode as well as during the Taper Tantrum of 2013. We normalized our EM currency index, which comprises 22 equally weighted liquid emerging market currencies, to 100 just before each episode to make it easier to compare.

As the chart shows:

1. While EM currencies corrected by around 6% during the Taper Tantrum, this time around the correction is less than 2%. This can also be ascertained from the ratio of the slopes of the two regression lines.
2. Just as importantly, the regression fit is quite poor this time around versus the strong fit during the Taper Tantrum, implying that the weakness in EM currencies since the start of the year may not be related to US yields alone but could be due to several factors, including idiosyncratic ones.

There are a few reasons for the differences in the performance of EM currencies in the two episodes:

• Valuations – EM currencies have underperformed other assets (see here) during the current recovery and are cheap in real effective exchange rate (REER) terms (see here). At the time of the Taper Tantrum, EM currencies were expensive in REER terms.
• Flows – EM local markets had received massive inflows before the Taper Tantrum, which is not the case this time around.
• External balances – At the time of the Taper Tantrum, several large emerging countries were running large current account deficits, making them vulnerable to a lack of external funding, the risk of which increased with higher global yields. External balances are in better shape in most emerging countries this time around.
• High risk premium built for vulnerable countries – Of all the emerging countries, the two that have weak macro stories are Brazil and Turkey. However, currencies in both countries had lagged significantly even before the correction in US Treasuries as we discussed in our recent notes (see here and here). As such, some of the risks were already priced in for the vulnerable countries.

While it is positive that so far EM currencies have not been hurt as badly as in previous similar episodes, it is too early to claim victory. Compared with the Taper Tantrum, the US 10y yield has adjusted by only half as much in the current episode. If the sell-off in US Treasuries continues, then more vulnerabilities may come to the fore, besides the known ones.

Data Source: Refinitiv; Note EM FX refers to equally weighted spot returns for 22 liquid EM currencies

Best Longs / Best Shorts

• Our list of underperformers in the attached FX Dashboard pdf is now empty as we removed the Philippine peso (PHP) from it with its z-score based on 3m changes dropping below 1.
• The list of outperformers stayed the same with the Taiwan dollar (TWD) on it. Indeed, TWD looks more expensive than previously with its z-score approaching 2.

Best Crosses

• Our list of preferred relative-value trades shrank a bit as it now consists of Long MXN vs Short the Australian dollar (AUD) or TRY or the British pound (GBP).
• The 3m expected returns for these pairs are in the range of 9.5-12.0% (not annualized), assuming mean reversion.
• We removed Long MXN vs Short the Canadian dollar (CAD) from it as its expected return dropped, which indicates that our recommendation has been working.