The steady weakness in EM currencies that started from April has now accelerated in recent days, attaining more traction following the unforeseen revelation in the FOMC minutes that a June hike is most likely.

However, there are self-limiting dynamics at play– if the dollar strengthens too much the Fed could turn less hawkish.  The combination of investors being starved of a tradable macro trend and poor Q1n performance after being caught long dollars earlier in the year provides a combustible environment.

Selective capital deployment and very low risk allocations, corroborated by the narrow offshore-onshore FX implied yield differential in Asia, suggests that positioning is very light.

Investors have a lot of dry powder to add fuel to the EM sell-off.  

EM currencies are particularly vulnerable as the starting point is quite unfavourable.

Relative EM vs DM growth is depressed and could deteriorate further if leading indicators are correct.

The net capital flow cycle (FDI, portfolio, and cross border banking) is weak and has been deteriorating ever since 2011.

The rebound in foreign portfolio inflows in March and April has reversed in May.  

Policy uncertainty is back in play, which was a key driver of EM weakness last year. The conditions are ripe for a sharp EM FX sell-off if US data cooperates, specifically payrolls released in early June, and the risks of destabilizing moves is growing if the timing/magnitude of Fed rate hikes is aggressively re-priced.

Our portfolio of trade recommendations is loaded up on long dollar exposure, either directly or through relative trades that are positively correlated to USD-EM.

Over the past couple of days we recommend adding the following positions, which still have attractive entry points and risk-reward:

Initiate longs in USDZAR futures contracts of near month tenors.

Initiate longs in USDPHP futures contracts of mid month tenors.

Buy USD/KRW 2W call spread with strikes of 1,185-1,191 for a net credit.

The KRW has already moved a lot, so it is not worth chasing at these levels.

The net delta of the position should be around 18, selling the far leg (OTM strikes) likely to reduce the cost of the ITM call by almost close to 40%. Maximum gain is 3.9% (ideal risk-reward).

Other Asian baskets are this way, short SGDINR and short MYRIDR are in positive territory but still have more upside (especially with carry) and good risk reward if USD-EM continues to rise.