Emerging Markets, MXN, RBI Suprise, Drop in Chinese Reserves

EM currencies could continue to stabilise over the next week ahead of the FOMC meeting, and MXN could bea beneficiary. The latest round of oil block auctions went well, with 80% of deepwater blocks successfully auctioned. USD/MXN could head down to 20. RBI’s surprise hold decision, looking beyond the transitory impact from the currency replacement scheme, shows that INR macro stability remains the focus in India. EUR/PLN is near multi-year highs and we believe PLN is cheap. Our economists expect some dovish commentary from the NBP today, which could provide a better entry point for long PLN. While valuations have played a big rolein the reported drop in China’s FX reserves, capital outflows are continuing and we expect to see more CNY weakness. The USD could stabilise in the near term ahead of next week’s FOMC decision. Long USD positions have been popular and as we approach yearend investors could be more inclined to reduce risk and lock in gains. While a rate hike from the FOMC is fully priced in. In such an environment, EM will likely do well.

Several EM currencies look cheap, including TRY and MXN. However, as we highlighted yesterday, we are not looking to participate in any TRY rebound. MXN, meanwhile, could have a short-term bounce. MXN outperformed yesterday, and we believe in the current environment of a USD moderation, this could continue. Adding further support to MXN are the latest round of oil auctions, which were quite strong, with an 80% success rate in the first set of deep water auctions. This is not to say we are sanguine about the risks that a protectionist US stance poses for MXN, and the potential for spillover to Mexico’s own domestic monetary political picture. The oil auction, while successful, is unlikely to change these risks – it simply removes a potential risk for the currency, rather than adding a strength. However, given valuation, the potential for a USD pause, and the strength of yesterday’s oil auctions, we do believe that the currency could keep stability, and even strengthen a bit more into year end.20 will be a key level for the currency, as it hasn’t traded below here since the elections. For now, we prefer to position in 2s/10s TIIE steepeners in Mexico.

The RBI surprised markets today by keeping rates on hold, against consensus expectations for a 25bp cut, as the committee awaits more clarity on the impact from the government’s currency replacement on growth and inflation. With base effects falling out of inflation starting in December and going into the expected Fed hike in December, the RBI observed caution in maintaining the real rate at 1.25% given its projected inflation rate of 5% by March 2017. 10y IGBs have sold off by ~16-18bps following the policy announcement. With future easing expectations getting priced out and system liquidity also expected to neutralize over the coming weeks we would expect a further correction in bonds. However, the RBI credibly keeping to its real rate framework and maintaining adequate buffer in preparation for the steepening global yield curves implies that macrostability remains a priority over growth. If the growth impact from currency replacement are indeed transient,as our economists expect, we believe a recovery in growth and equity markets would be supportive of the INR.

The slightly larger than expected drop in China’s FX reserves was the biggest monthly decline since Jan 2016, but will to a large extent reflect changes in exchange rate and bond valuations, since the USD rose by about 3.5% versus the majors and US bond yields rose notably. Nonetheless, China continues to experience capital outflows and some FX intervention has occurred, as noted by SAFE. The authorities responded to outflows by imposing new restrictions at the end of November, but we expect continued medium-term depreciation in the CNY. China’s November trade data will be released on December 8,and our economists are more or less in line with consensus with their expectations of – 4.7% and -2.0% export growth, respectively. Trade data from Asia for November has so far been upbeat, with both South Korea and Taiwan posting better than expected export numbers. While positive, we believe that the expected medium term slowdown in China combined with uncertainty over the future of global trade ,as well as domestic constraints on growth, will lead to currency weakness for both KRW and TWD over the medium term.