FX Dashboard: Updating the Winners and Losers in the EM Turnaround

Since the end of March, the dollar index has weakened 3.0%, leading to a very supportive environment for EM currencies, which have appreciated 3.2% on average since then. In a previous note from a month ago, we discussed the outperformers and underperformers among EM currencies as they recovered from their worst levels since the start of the year.

Over the past month, the dollar has strengthened marginally, but the drop in the volatility of the US dollar has been sufficient for EM currencies to continue appreciating, albeit at a slower pace. Plotting the performance of individual currencies against their betas (see the left chart below) shows the strong correlation among EM currencies in the recovery.

The right chart below isolates the excess performance, positive or negative, of each currency versus what is implied by their respective betas.

As the chart shows, the currencies that have outperformed are:

• The Brazilian real (BRL) has been the best performer as it makes up for its significant underperformance last year when fiscal concerns had ratcheted up. Indeed, the currency was more than 20% cheap in real effective exchange rate (REER) terms before the turnaround, as we highlighted in a previous note. The factors that combined to make BRL the best performer are the dollar weakness, an agreement between Congress and the President to effectively kick the fiscal can down the road, and the interventions in the FX market as well as aggressive rate hikes by the central bank with more to come. Our view is that while BRL remains cheap in REER terms, it is going to be volatile until the presidential election next year, with opportunities to capture large moves in both directions.
• The Central European currencies – the Hungarian forint (HUF), the Polish zloty (PLN), and the Czech koruna (CZK) – have performed well as expectations of rate hikes have built up with growth and inflation expectations picking up. The recovery in the euro (EUR) against the dollar has also helped. The Romanian leu (RON) has been the exception in the region leading us to recommend Long RON/Short CZK.
• With a current account balance exceeding 13% of GDP, the appreciation pressure on the Taiwan dollar (TWD) remains strong. The US Treasury holding back on labeling Taiwan a currency manipulator (see here) provided further impetus to TWD as it meant that the central bank’s currency interventions would likely drop.

With regards to the currencies that have underperformed:

• Idiosyncratic developments have led the Turkish lira (TRY) and the Peruvian sol (PEN) to be the worst performers. We have discussed the factors behind the poor performances of these currencies in previous notes (see here and here).
• Three Asian currencies – the Indonesia rupiah (IDR), the Thai baht (THB), and the Indian rupee (INR) – have underperformed, mainly because of the resurgence of coronavirus which hurt their growth outlooks. We expect their performance to pick up as the growth recovery has likely just been postponed and have a recommendation to buy IDR vs the Singapore dollar, and are timing the entry into THB and INR (see here and here). INR, in particular, we like because its high carry relative to its volatility makes it an ideal currency in a low-volatility-driven carry environment.
• The Mexican peso (MXN) is one of our preferred currencies (see here) and we are currently recommending Long MXN versus Short the Canadian dollar (CAD).
• The combination of street protests and rating downgrades has weighed on the Colombian peso (COP). With the central bank likely to raise rates in our view, we are monitoring the currency for an entry point (see here).

Data Source: Refinitiv; Note: EM FX = equally weighted spot returns of 22 currencies

Best Longs / Best Shorts

• The list of underperformers based on our models in the attached FX Dashboard stayed unchanged with PEN, THB, and the Romanian leu against the euro (EURRON) on it.
• From the list of outperformers, we removed the Philippine peso (PHP) and the Polish zloty against the euro (EURPLN), while adding TWD.
• The list already consisted of the Hungarian forint against the euro (EURHUF), BRL, the South African rand (ZAR), and the Czech koruna against the euro (EURCZK).

Best Crosses

• The list of preferred relative-value trades based on our models shrunk to Short BRL vs Long THB or COP or PEN.
• The 3m expected returns for these pairs are high in the range of 12-12.5% (not annualized), assuming mean reversion.