Fixed Income

EMD Relative weekly notes

Week Ending March 17, 2017


James Barrineau

James Barrineau

Head of Emerging Markets Debt Relative

If the pricing-in of three rates hikes within 10 months, and the delivery of the first of those hikes, can't make the USD rally from current levels, what can? If you have trouble answering that question, we think one may wish to consider the emerging markets.

The Fed's first rate hike delivery this week, which was well anticipated and dovish only in the sense that it confirmed market expectations, actually caused the dollar to weaken. The chart below of the past ten days of market action shows the Fed jolted the dollar from a narrow short-term trading range. While it seems to us unlikely that the dollar could decline meaningfully from here due to growing interest rate differentials, one could have made the same argument against the current market moves some weeks ago. In assessing why we were among those who assumed the dollar would remain strong or stronger even as the Trump reflation trade cooled off, we think we have not sufficiently appreciated that currently all major central banks are moving in the same direction towards tighter policy, albeit at widely varying speeds.

Source: Bloomberg, DXY Dollar Index. Data as of March 17, 2017. Past performance is no guarantee of future results.

By contrast, the 2013-2015 period--when EM FX had its worst run in history--was marked by the Fed signaling and then beginning to wind up quantitative easing even as the European Central Bank (ECB) and Bank of Japan (BOJ) were moving more deeply in an easing direction. As long as directionality is consistent, it seems to us the market is currently signaling that the dollar should be range-bound-to-weaker, after the 2013-end of 2015 run-up of about 24%.

Almost needless to say, we assume, is that a weaker dollar raises the probability for stronger EM currencies which can mean more liquidity into EM countries, and, if history is any guide, the potential for higher asset prices. Additionally, EM countries have a strong growth advantage over DM countries, and inflation is broadly declining while inflation creeps up in the developed world. A weaker-to-stable dollar makes the probability of those positive relative trends continuing significantly higher, in our opinion.

We are quite sensitive to the possibility that one area of policy divergence not factored in, apparently, remains a turn in fiscal policy in the US towards more stimulus. That could short-circuit the current positive conditions for emerging markets if the dollar were to rise meaningfully in response. But it seems clear that such action is months away--if it occurs at all--and the possibility remains that a broadly neutral tax package that does not expand the US budget will not be perceived as stimulatory. In the meantime, we feel the current conditions check all the boxes that are consistent with robust asset price gains.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.