The US Federal Reserve has left the market confused. In May, the market was in a general agreement that the US economy was a modest road to recovery. Policy normalization would come, but not quite yet. However, the Fed seemed to have a different idea, with Fed chairman Ben Bernanke raising the possibility that they could taper policy in the very near term.
Unfortunately this was out of sync with many EM economies and a number of central banks found themselves forced to hike rates (to support their currency) at the very time they had been looking to loosen policy. The high inflation (due to the currency move), low growth (due to higher rates) and higher potential returns from the US (as a result of tapering) encouraged capital outflows from EM markets, putting more downward pressure on the EM FX. For countries with large current account deficits, the possibility of a currency crisis started to raise its ugly head.
There was no let-up in June when the Fed presented a more optimistic view of the labor market. Similarly, when the August FOMC minutes revealed that "a number of participants" thought that market expectations for tapering and policy rates were "well aligned with their own expectations", a SepTaper seemed a done deal. In fact, the message was so clear that going into last night's announcement, the whole market expected the Fed to taper by USD 10-15 billion - taking the monthly purchases to USD 70 billion.
Consequently, markets were left reeling following the Fed's decision NOT to taper. This message was reinforced by their more dovish outlook and surprisingly low median forecast of 2% for Fed funds rate in 2016.
The reason: the committee wanted to "await more evidence that progress (on improving economic activity and labor market conditions) will be sustained". In other words they want to be more comfortable that interest rate sensitive parts of the economy, such as housing, can withstand a tightening of financial conditions. As it was the Fed's very communications that caused the tightening of financial conditions in the first place, it seems hard to imagine that they didn't anticipate a steepening of the US yield curve and factor it into their outlook.
EMERGING MARKETS BENEFIT
The news was negative for the USD and positive for EM FX in particular. With tapering likely delayed until at least the end of the year, the respite for EM FX could well continue into year end. However, with the market likely to be less confident that it can properly interpret the Fed's communications and with the Fed putting even more focus on how US data evolves, the path is likely to remain bumpy.
The longer term trajectory for EM FX will depend on 1) how far the Fed kicks the "can down the road" and 2) how much homework each EM country does. All the Fed has done is delay when they will start normalizing policy. Moreover, it is also not clear if the delayed start will translate into a delayed finish. A run of stronger data could just mean they move faster and still finish in the middle of next year. Consequently, the onus is on EM economies to change their outlook. Otherwise there is a risk that the summer's sell-off is repeated in the New Year.
Changing the structure of an economy is never an easy task, and for Indonesia, India and Brazil the upcoming elections are likely to make it even more challenging. It is hard to see how current account deficits can be meaningfully reduced, while capital accounts are shored up if these currencies make a sustained rally from here. Consequently, we remain cautious over the long term prospects of the TRY, ZAR, IDR, INR and BRL for now.
In the EM space, the currencies we continue to like over the long term are those with current account surpluses (KRW, MYR, RUB, CNY). In our opinion, the MYR is particularly interesting. The MYR was caught up in the EM sell off because it is 1) liquid and 2) has a local bond market, which is 48% owned by foreigners.
However, its other fundamentals are healthy. Growth is decent, rate hikes may be on the way and the economy has a current account surplus. While this surplus is declining, we believe there is a big difference between a deteriorating current account driven by good reasons (investment, Malaysia) and a consumption binge (India). We also remain bullish on the MXN, as the news suggests the Fed will keep policy rates low at the same time as US growth improves.
ACROSS THE DEVELOPED ECONOMIES
In the G10 space, the onus now shifts to other central bankers to see if they can respond with a dovish ace of their own. We think they will try. Only last week European Central Bank (ECB) president Mario Draghi reiterated the bank's forward guidance that interest rates will stay on hold or be lowered for an extended period of time due to the fragility of the euro area economy. We expect this message to be reinforced at his next ECB press conference on October 10.
As such, we continue to believe that EUR/USD will remain range bound between 1.36-1.28 over the medium. Nonetheless, with EUR/USD already close to its upper bound, there is the possibility that better-than-expected euro area data (or worse-than-expected US data) combined with likely EUR/USD stops around 1.36 could cause a temporary, near-term breach of the range to the upside. We would fade such a move.
Bank of England governor Mark Carney has not shared Bernanke or Draghi's success in communicating that UK rates are likely to stay on hold for a protracted period of time. Unfortunately his opportunities to change this are more limited. The next Inflation Report press conference is in November, the September MPC minutes are not published until mid-October and according to the Bank of England's website, he is not scheduled to speak in September. This suggests the only near-term tool to bring down GBP/USD is a change in the MPC rate/QE decision. But with the UK economy showing robust growth, a change to either of these seems unlikely. Consequently, it is hard to see GBP/USD pushing meaningfully lower just yet.
Outside of Europe, the Reserve Bank of Australia's (RBA) September minutes once again revealed its preference for a weaker currency when it commented that "some further decline in the exchange rate would be helpful". As AUD/USD was close to 0.90 at this point, a more dovish communication in October is not out of the question. We remain bearish on AUD/USD with our one-year forecast at 0.85.
Finally, we remain bullish on USD/JPY and USD/CHF. In our opinion, while the news overnight may slow the pace of USD appreciation, it does not change our view that Abenomics is likely to lead to more JPY weakness. Similarly, we continue to believe that the CHF will depreciate as confidence in the euro area picks up.
Sara Yates is global head of FX Strategy at the London office of J.P. Morgan Private Bank.
© Zawya 2013
