Fixed Income

EMD Relative weekly notes

Week Ending April 29, 2016


James Barrineau

James Barrineau

Co-Head of Emerging Markets Debt Relative

This week was a lesson in how important the US dollar is to emerging market returns and fundamentals. We will end April with about a 1.6% fall in the DXY dollar index, which follows a sharp 3.4% fall in March. Markets have clearly picked up on a weakening dollar trend, with lots of analytical commentary coming across opining on the drivers. We believe a trend that becomes widely recognized as such typically has more room to run. Last week we talked about valuations in the context of a sharp move higher in emerging market asset prices; this week we discuss the dollar driver, and why it remains supported.

On Wednesday, the Fed delivered what we believe was more or less a neutral meeting for the markets, and broad asset price movements post the Fed meeting were subdued. But an initial 0.5% reading of Q1 GDP for the US suggested growth was probably not strong enough to change the current market pricing of little chance for a rate hike in coming months—a dynamic which is supportive of the weaker US dollar. Furthermore, the Bank of Japan surprised markets by not delivering additional stimulus in an expected dose, and the yen soared against the US dollar. After an initial modest sell-off in risk assets, the market seemed to conclude that a stronger yen probably meant a more broadly weak dollar, and other major currencies advanced against the dollar as the week ended.

Most encouraging for emerging markets and their associated currencies was that neither a wobble in US equities this past week nor the lack of Japanese stimulus translated into a risk-off episode--the local currency index rallied on the week, and will likely finish the month up more than 2%. Therefore, it seems safe to conclude that the deepening conviction that the dollar will weaken has become broadly recognized as a very positive driver for EM assets.

We think the chart below provides visual evidence of this thesis. It shows the dollar index since 2011 with an inverted chart of the JP Morgan GBI-EM local currency index. The correlation is striking (though perhaps not precise), and it suggests that a weakening dollar is a necessary, and perhaps sufficient, condition for the positive tone in EM assets to continue. Events this past week, in our view, should be seen as reinforcing a conviction that the fundamental conditions underlying the trend are intact.

Source: Bloomberg; data as of April 29, 2016. DXY is the US dollar spot Index, a widely used proxy for currency valuation relative to foreign currencies. Performance shown reflects past performance, which is no guarantee of future results.


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