EM and risk outlook stays relatively supported but we see risk aversion alert signs across the board. While investors focus on US politics and especially on today’s vote on the repeal act of Obamacare, other developments should, in our view, not remain unnoticed: a research paper published by two Fed economists and released by the Brookings Institute suggesting US interest rates staying low with the Fed tolerating inflation overshooting targets, the ECB’s targeted LTRO allocations, and the continued fall of iron ore futures. Despite equity markets retracing some of the post-election rally, US monetary conditions have become more accommodative with the falling USD contributing most to this easing. Foreign conditions have turned from providing hefty headwinds as experienced from 2012-16 into tailwinds, helping US reflation gain momentum over time. Accordingly, we prepare for putting on FX trades that benefit from a steeper US yield curve. Short EURSEK and long USDJPY fall into this category. While short EURSEK should work from now, USDJPY’s current downward momentum suggests waiting for 109.50 or for a stabilisation above 112.50 before establishing longs.

US vote: Today markets will wait for the outcome of the vote but FX investors should note that the vote is not scheduled for a specific time. At the moment the vote count may be low so the Republican leaders need the time to gather votes, indicating why no specific time is provided. There is even a risk the vote may be delayed if the leaders feel the vote may not pass.

Watching iron ore. The PBOC-run Financial News newspaper highlighted that the recent rise of RMB money market rates should be put into the context of recent money market operations. China seems to be tightening its monetary conditions to deal with excessive leverage. Importantly, tighter RMB lending conditions have sparked China’s USD denominated loan demand, pushing its USD denominated liabilities up again. Should this loan-related USD inflow into China end up into a higher FX reserves (see chart below) – thus providing an additional signal that offshore USD liquidity conditions are on the rise – EM markets should see further inflows. Meanwhile, China has seen the ratio of mortgage loans to total credit of commercial banks reaching uncomfortably high readings. It has been China’s property and infrastructure investment driving commodity – including iron ore – demand. Authorities are now directing growth away from the property market which suggests that commodity prices may ease. Falling iron ore prices will not bode well for the AUD. Within this context we recommend using the AUD as a funding tool for high yield EM longs and for a long GBP position. GBPAUD has moved away from levels suggested by relative forward curves.

A rate hike from the US Federal Reserve’s Federal Open Market Committee (FOMC) today is almost a certainty. The policymakers would conclude their two days of meeting today and announce the decision at 18:00 GMT, followed by a press conference by the Fed Chair Janet Yellen. As of data available for March 14th, the participants in the financial markets are pricing with 91 percent probability that there will be a 25 basis points rate hike. The market is pricing the next hike to be in June and the third hike to be in December.

We have prepared an FOMC dashboard that segregates members in three distinct groups, Hawks, Doves, and unknowns based on their remarks and commentaries made in public forums, focusing on the March interest rate decision. That dashboard is also suggesting that there will be a hike today. We have found that except for Minneapolis Fed President Neel Kashkari, all the other members are hawkish heading to the rate decision. We also couldn’t confirm the views of Daniel Tarullo, who has recently resigned and this is his last rate decision meeting.

The US dollar index is currently trading at 101.38, down 0.25 percent for the day. The dollar has been struggling to head to higher highs despite a full market pricing (almost) of a hike in March and three this year. So, the dollar index might see selloffs after the interest rate decision if the inflation and interest rate outlooks are not substantially upgraded beyond what was shared in the December projections. In addition to that, the major focus is on the Dutch election this week, for which the results would start appearing after the FOMC meeting.

Monthly Global EM Outlook, Trump Policies and Inflation

From the current starting point, the near-term inflation outlook is generally unthreatening in most markets that have a large weight in the international benchmark indices for EM local currency debt.

Inflation has risen in some EM countries during the past half year in response to currency depreciation and increases in global oil prices; but the CPI impact of exchange rate weakness has in most cases diminished and the oil price effect is probably about to peak. Beyond the group of EM countries that now have large weights in the EM debt indices, it is notable that core inflation is on the rise in China.

 The current level of core inflation (2.2% year-on-year) is not seriously disconcerting but if it continues to creep upwards then it will eventually become a constraint on China’s monetary policy. This represents a risk for the entire EM/commodities complex, but it is more likely to be a risk for the second half of 2017 than a focal point in the next few months. More imminently, the main risk of abrupt policy rate increases in the EM universe comes from the US in the form of the possibility of a surprisingly large batch of Fed rate hikes during the remainder of the year and/or a border adjustment tax. Either of these shocks could force a swathe of EM central banks to choose between raising their policy rates substantially or having to live with undesirably steep currency depreciation.

Given the current predominantly unthreatening EM inflation trends and residual labor market capacity slack in many countries, a large share of the EM central banks – especially in Asia – look set to be able to leave their own policy interest rates unchanged if the Fed keeps raising rates at a gentle pace and if the US border adjustment tax fades away.

An important source of inflation volatility in the EM world in recent years has EM currency depreciation (in nominal trade-weighted terms) that has led to increases in prices not only for imports, but also for those domestically produced goods that compete against foreignproduced items either in the domestic market or the export market. However, this problem dissipated in most of the EM world during the course of 2016, and only a few of the large EM countries – Mexico and Turkey to be precise – are seeing this problem unfold right now

Two other large EM countries – Brazil and Russia – are in the opposite camp. Inflation has fallen sharply in both countries in the past year. This reflects in part a swing from large-scale currency depreciation in late 2015 and early 2016 to equally forceful currency appreciation during the past 12 months. Deep recession, widening output gaps, and cautious monetary policy in both countries have also helped contain inflation. The view of our Brazil-based economists is that recent currency appreciation will continue to help drive down the country’s inflation in the present year whereas the main drivers of last year’s fall in inflation were a large decline in the pace of adjustment in government controlled prices (in part reflecting currency dynamics and a big change in global oil price inflation), the depth of the recession and, related to this, weakened wage pressure in the labor market.

To be sure, the behavior of EM currencies, inflation and policy rates would be highly likely to become much messier if the Fed were to accelerate the pace of its rate hikes substantially beyond what is currently priced into the US rates curve, perhaps in response to stronger wage data or aggressive future plans for unfunded US tax cuts. There is also, in our view, a very real risk to EM investors associated with the plan of Republican members of US Congress for border adjustment taxation (BAT), or from the possible imposition by the US of other types of import taxation. As we have argued multiple times on these pages, the BAT and import tariffs are likely to be highly dollarsupportive. If Trump’s decides to support either, and if he secures congressional approval, dollar-based holders of EM local-currency-denominated assets are likely to take a hit.

It might seem inviting to think that the BAT would help curb inflation in the EM world, because it would be likely to drive down the dollar price that EM-based importers pay for goods from the US (as US exporters would be entitled to a new subsidy) while also driving down the dollar price that EM-based exporters would obtain from sales to the US (because their sales would be subject to taxation at the US border). But the inflation “benefit” would be eroded by EM currency depreciation against the dollar. EM currency depreciation would most likely be sufficient to drive the local-currency prices for EM countries’ exports and imports (in trade with the US) almost all the way back to their pre-BAT levels.


Turkey MPC decision, money markets and inflation indexes

Following the MPC decision on Tuesday (24 January), the central bank provided all of its funding at the upper end of the interest rate corridor (9.25%), not at the late liquidity window (11.00%) yesterday. The central bank’s effective funding rate increased accordingly to 9.25% from 9.12% a day ago when the central bank had provided a mix of funding at the upper end of the corridor (8.50% then) and the late liquidity facility (10.00% then). The adverse market reaction to this development shows the significance of the marginal funding rate for the lira’s exchange rate, in our view – although the central bank’s effective funding rate increased yesterday compared to the previous day, its marginal funding rate declined to 9.25% from 10.00%, which did not support the lira. Meanwhile, the overnight FX swap rate declined to 8.00% yesterday from 9.39% a day ago.

The Statistics Office announced methodological revisions for the inflation statistics yesterday. There were adjustments in the weights of food prices (reduced by about 2pps), transport prices (increased by about 2pps) and housing and utilities prices (reduced by about 1pp). The Statistics Office also said that it will use a new methodology for the prices of seasonal products (which would be particularly relevant for unprocessed food items). The Office expects about 10% less volatility in the CPI index with the new methodology, but these changes will not impact the trend of inflation. The Statistics Office will also release new measures of core inflation, but will continue to release core indices H and I, which are widely used.

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.



USD, Asian Equities, Emerging Markets and the JPY

There is a positive tone in Asian equity markets as USDJPY has marched through the key 110 level and won’t find any resistance before 111.45. The USD’s upside momentum is likely staying in place with the real yield differentials still leaving USDJPY about 3.5% under-priced. Yesterday it was the release of US second tier data and Fed’s Yellen suggesting that a rate hike could be imminent pushing US bond yields higher towards the 2.33% seen for 10y this morning. US 10y real yields have risen and are now at levels seen in March. The sustainability of the risk rally in this environment may depend on whether real yields are rising too fast relative to the improved earnings outlook (from expected fiscal stimulus).

Since 2006, the average bond duration held in benchmark portfolios has increased from 6 to 8 eight years (figure as of 2 weeks ago) and with market maker (banks) inventory books smaller due to regulation, portfolio adjustment pressures have the potential to increase real yields. In this case, the USD rally would turn less risk friendly. Globally, bond market valuations have lost USD1.5trn from their peak launching a dose of tightening of financial conditions. Looking at Bloomberg’s measure of financial conditions, we note that AxJ has particularly tightened, with a limited impact on the US or Eurozone for now. For us the price of capital is only one component to look at. The other component is the availability of capital best expressed by the money multiplier, which has increased in the US. This leaves our focus as the evolution of US real yields. Should portfolio liquidation pressures increase real yields early then the selling into high yielding EM will intensify.

Coming back to the JPY, Japan’s Aso calling recent market moves a ‘normalisation’ suggests there is more room for JPY depreciation. Concretely, Japan needs a higher money multiplier which requires banks to use their balance sheets more actively, which itself is a function of bank profitability. Japanese interbank lending volumes have doubled since their April low but are still only a mere 37% of the volume lent in January, suggesting there is room for improvement, weakening the JPY. The stabilisation, slope and volatility managed yield curve does help, but given Japan’s high debt levels the yield curve cannot do the entire heavy lifting of enhancing bank profitability. The help of a weak exchange rate is required. Japan’s authorities may act and communicate accordingly.



Turkey: S&P upgrades Turkey’s outlook to “stable”

S&P changes Turkey’s outlook to “stable” from “negative”, while rating the Turkish economy at “BB.” S&P revised Turkey’s outlook up to “stable” from “negative” in its last regular assessment for this year, while keeping “unsolicited” foreign and local currency credit ratings unchanged at ‘BB’ and ‘BB+’, respectively. According to the agency, the upgrade reflects the Turkish economy’s resilience against regional and domestic risks, while it believes policymakers will continue to implement reforms for economic stability. The country’s internal environment was also considered in the decision to revise the rating, while the state of emergency following the coup attempt in July 2016 is predicted to remain in place until at least January 2017. The announcement came after markets closed following a busy day with a sharp increase in USD/TRY to all-time highs on the back of local political developments.


Turkey Trade Balance and TRY

The trade balance came in at USD4.4bn in September, while the 12M rolling deficit stood at USD56.2bn, a slight increase over the previous month from the lowest level since mid-2010. The foreign trade deficit, at USD4.4bn in September, raised the 12M rolling deficit to USD56.2bn, from the lowest in six years at USD55.7 a month ago. This is likely a reversal in the long-term trend since end-2013 given the gradual decline in the supportive effects of commodity prices and ongoing risks due to geopolitical tensions. Following strong YoY growth rates recorded in August, both exports and imports contracted by 5.6% and 0.7%, respectively, translating into a 14% widening of the merchandise trade deficit in September over the same month of the previous year. As a result, coverage of imports by exports dropped to 71.5%, showing the impact of expansion in core trade deficit (excluding gold and energy), which, on a 12M rolling basis, also widened slightly.