Emerging Market Rally Getting Overstretched, Look For Weakness Next Week

Currency performance this week:  The biggest EM gainers vs. the dollar this past week were HUF, RON, CZK,PLN, MXN, TRY, and ZAR, while the only EM losers vs. the dollar this past week were RUB, PHP, CLP, COP, IDR, and ARS. 

  • Market overview:  EM saw a strong week, as risk on trading persisted despite mixed US data.  We remain nervous about risk appetite, as most EM currencies are trading at very stretched valuations despite ongoing concerns about US and global growth.  Risk appetite is likely to remain in flux, and the fact that peripheral bond spreads are at or near record highs tells us that stresses in Europe remain in play.  We remain cautious, and think that the backdrop for EM has not improved quite enough to justify current valuations.  In this environment, we would continue to focus on intra-EM plays that favor countries with good fundamentals (Asia, Latin America) over those with weak ones (EMEA).  Indeed, many EM currencies are looking a bit tired after this month’s rally and so we look for EM weakness in the week ahead.
  • Risk of capital controls in EM rising:  Local press is reporting that Colombia policy-makers are mulling capital controls to stem peso appreciation.  Central bank official said that the strong currency was a concern because it is the result of short-term capital inflows.  Earlier this year, officials pledged greater intervention “when appropriate”, but latest comments are another step up the ladder.  Clearly, many EM countries are still nervous about a strong currency from potentially destabilizing hot money.  Given moves this year by Indonesia, Korea, and Taiwan to control hot money, we expect nervousness about spreading capital controls to remain in play if the EM rally continues, and will most likely slow down EM gains a bit. 
  • Russia facing a different problem:  We believe USD/RUB remains an oil play, as the 60-day correlation with Brent crude oil price stands at -0.4888.  This is down from -0.7362 peak in June but is still quite high.  USD/RUB is trading at its highest level since July 1, when Brent oil was trading around $72.  Brent is currently around $79 (+10%) and yet the ruble has weakened about 5% since then.  If optimism regarding the global economy continues, higher oil prices should support the ruble.  RUB is worst performing EMEA currency so far in Q3, which we do not think is warranted given the improved global outlook.  As such, this current ruble weakness should be viewed as a buying opportunity to get in on the global growth trade at a cheap level.  Fundamental trajectory for Russia remains solid.  Earlier this month, Fitch raised the outlook on Russia’s BBB rating to positive from stable, citing stronger growth and a more flexible exchange rate as positive factors. 
  • NEW TRADE RECOMMENDATIONS:  Given our views on Russia (see above), we would go short USD/RUB at current levels around 31.16 for a catch up move with oil prices.  Long-term target is the August low around 29.672, and intermediate targets are 30.72, 30.52, and 30.32.  Stop should be placed at 31.75.  We remain negative on Romania, and look to re-enter a long EUR/RON position at current levels around 4.25 for a move back to the September high around 4.30 and then the June high around 4.40.  Stop should be placed around 4.20.
  • UPDATED TRADE RECOMMENDATIONS:  We went long CAD/MXN around 12.57 for a move back to the all-time high around 12.85 from back in October 2009.  We are losing on this one, and our stop was placed at 12.40.  We went long PLN/CZK around 6.25 for a move back to 6.42 (June high) and then 6.66 (2010 high from March).  We are breaking even on this, and stop was placed at 6.15.  We got stopped out of our long USD/ZAR trade at 7.15 for a loss .  We went long USD/CLP around 497 for a move back to 517 but are breaking even.  Stop was placed at 490. 
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