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The short-term repricing of Fed hikes is typically not supportive of EM FX returns, which also motivates our selective hedges (e.g. TRY and MXN). The recent research in the past emphasized the distinction between increases in core yields driven by rising breakeven inflation (good bond sell-off) versus rising real yields (bad bond sell-off).
The above nutshell illustrates the episodes since 2013 that saw another Fed hike being priced in by the market over a 1m period. Typically, EM FX had negative returns over those periods, although there were some which did not conform to this, such as in March 2016 when EM was going through a cyclical recovery from the lows, and in January 2018.
Three Fed hikes are currently priced in for the next 12 months, and our economists see a likely revision to the Fed dot plot at the March FOMC meeting to indicate four hikes this year. This could add some short-term pressure to EM FX in the run-up to the meeting.
Trading tips:
We are neutral EM FX amid a more balanced short-term risk outlook
EMEA FX: We are MW in EMEA EMFX emphasizing RV plays. In CEE, we now have the highest conviction on our tactical short EURHUF trade added last week. Our conviction on short USDPLN has dropped, but we still believe the direction will be lower for the currency.
EM Asia FX: Neutral in the GBI-EM Model Portfolio but outright longs in SGD, KRW, and TWD, as EM Asia FX strength can play a part in mitigating trade tensions over the medium term.
Latin America FX: Maintain long JPYMXN and long USDCLP. Keep OW BRL and ARS, and UW MXN on medium-term considerations and UW PEN as a hedge.
In a standard carry trade, one takes advantage of a positive interest rate differential between two currencies. This position tends to perform in an environment of depressed volatility since the limited FX risk preserves the yield. However, the long high-yielding currency is almost always pretty volatile when it falls (think of emerging currencies), so the incremental carry profit can be destroyed in a wink if market sentiment deteriorates.
Sell 1Yx1Y USDTRY FVA vs buy 1Y ATM call.
Buy USDTRY call (4.00) and EURTRY call (4.83) (equal weighted USD notional).
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