Emerging markets led by local conditions as dollar rally pauses

Have the big global themes of a strong dollar and a slowing China gone away? Not a bit of it. But a pause in the dollar's rally is bringing investors' focus back on to local conditions in individual emerging markets.

There is consequently, as Luis Costa of Citi tells EM Squared, "a lot of price action in EM FX". Other analysts note that sharp movements in some currencies are being accentuated by a worsening shortage of liquidity - opening up further trading opportunities.

The challenge is to weigh several factors in the balance. Mr Costa, a currency and credit strategist at Citi Research, says last week's weakness in the South African rand reflected pessimism over China's reluctance to stimulate its flagging economy, darkening the outlook for South Africa's iron ore exports. When China then surprised by cutting bank reserve requirements at the weekend, releasing cash for lending to business, the rand stabilised.

Mr Costa and others think it still has room to fall. Peter Attard Montalto of Nomura put on a trade this week betting that the rand will fall beyond 12.90 to the dollar, from 12.10 when he opened his position (and about 12.26 on Thursday morning). He says investors are underestimating the risks posed by South Africa's power crisis and by the fallout from an expected rise in US interest rates.

He is even more bearish on the Turkish lira, which he is betting will fall through 2.90 to the dollar from 2.685 at the start of his trade (and 2.73 on Thursday morning). The immediate threat to the currency is Turkey's election on June 7, which he expects to do little if anything to reduce political instability.

Mr Attard Montalto says big moves in these and other currencies are more likely than before because of ever-reducing market liquidity. The effects can be seen, for example, in intraday volatility, currently at levels not seen since the September 2013 peak of the "taper tantrum" or the January 2014 EM currency sell-off (see charts). Given the absence of comparable events roiling markets today, he says, such big moves are "even more worrying".

Big moves have been seen in the Russian rouble, but in the opposite direction from the rand and lira. Mr Costa puts this down to a "classic short squeeze" - investors, from institutions to Russian households, became strongly short the rouble and long the dollar, which was fine while it worked. "Many real money firms are still underweight Russian bonds in their portfolios and that's become very expensive and painful to hold as yields come down [and prices go up]. As the industry tries to go more market weight we'll see more positive moves in rates," he predicts.

The Brazilian real, too, has recovered from recent lows - perhaps because, while the country's political, economic and corruption crises remain far from resolved, at least the initial panic has passed. "Everything was trading like credit," Mr Costa says. "Now we're into another chapter where some assets trade differently, with their own stories."

There is "no reason at all", he says, to expect any change in the secular strengthening of the dollar, nor the negative impact on many emerging markets of China's falling demand for commodities and other inputs. But look around the EM universe and divergence is clear. Mr Costa points to big variations in the exposure of EM corporates to dollar-denominated debt (see table below) as one indication of vulnerability to rising US rates. The trick is to stay ahead of the price action.

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