EM FX and bonds: the hunt moves indoors

  • Written by 

    By Petr Krpata

  • 25/03/2014
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Emerging market (EM) assets, as a group, are down year-to-date, but their performance is not the same across the board. Importantly, EMs look to be less driven by external risks as local factors begin to matter more; the Russian ruble (RUB) is a case in point. We prefer EM hard currency bonds to local and remain cautious on EM FX in general.

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US yields and current account positions are no longer key drivers

Since the sell-off in the second half of January, EM assets have stabilised, yet, as a group, they have not returned to their start of year levels. Equities are down, sovereign yields are up (though yields of hard currency debt are very close to its 2014 starting levels) and FX is still down against USD. While this seems like a 2013 déjà vu, some things have changed. As Figure 1 shows, the correlation of EM assets (fixed income and FX) with US Treasury (UST) yields has dropped meaningfully this year, suggesting that the US monetary policy outlook is no longer a key driver of EM assets.

Moreover, this year EM underperformance is not necessarily broad-based. For example, the Indonesian rupiah is up against the US dollar, while some sovereign local bond markets have also recorded positive returns so far this year (such as Malaysia). Indeed, we now see EM assets being driven more by domestic factors, rather than external influences.

Figure 1: EM assets not as exposed to UST yields

As Figures 2 and 3 depict, the market no longer looks to be solely focused on current account positions, and we observe a breakdown in relationship between current account positions and currency performance. As the drivers behind EM assets are changing, the key question to consider is how this change (and the price action of recent weeks) affects our EM fixed income and currency views.

Figure 2: Current accounts drove EM FX in 2013 and Figure 3: ...but this relationship has now dissipated

EM bonds – better than in 2013, but still not a clear buy

The sensitivity of EM rates to external factors (UST) has faded this year, as we noted above. This is good news for the asset class, as it should be less exposed to the vagaries of US yield movements and should be more influenced by domestic factors. Moreover, the recent selloff and the subsequent valuation adjustment mean that the asset class is no longer overly expensive. In fact, depending on the EM local bond index (and the underlying weights) used, one can even argue that on some measures valuations look fair or even attractive.

Risk-reward consideration favours EM hard currency debt to local

But, despite some progress on the EM bond front, we retain a cautious stance and remain underweight within our TAA. While the asset class now appears to be uncorrelated with US yields (and in turn more resilient to external factors), we would be surprised if the anticipated rise in US yields (above 3%) did not at least partially affect EM yields, dragging them higher.

Within the EM debt asset class, we see more favourable risk-reward characteristics in hard currency debt over local. Both offer a similar level of yields (Figure 4) but entail a different amount of risk, as hard currency bonds are not potentially exposed to further EM FX weakness and volatility. Indeed, as Figure 5 shows, historical realised volatility is lower for hard currency debt, meaning that the risk-adjusted returns from EM hard debt are higher if yields are broadly similar. Because of this, we prefer hard currency debt to local within the asset class, despite the hard currency index containing more credit risk (with its allocation between investment grade-rated and high yield bonds at 74%/26%, compared to 95%/5% for the local currency index).

Figure 4: EM hard and local debt offer similar yields and Figure 5: ...but the volatility is vastly different
Figure 6: Russia's current account surplus fell sharply and Figure 7: ...and its inflation is firmly above the target

EM FX − cautious view, but differences start to emerge

Although valuations have adjusted materially, we retain a generally cautious stance on EM FX due to the challenges some countries still face, whether that might be a need for structural adjustments, or upcoming election risks. On the latter, Hungary, South Africa, India, Indonesia, Brazil, Romania and Turkey all face elections this year. This, coupled with our high conviction view on USD strength in the quarters to come, bodes less well for the EM currency outlook overall.

Outlook for EM FX remains challenging

While the South African rand (ZAR) and Turkish lira (TRY), the two currencies that were at the centre of the January sell-off, have stabilised in recent weeks (due to overstretched short positioning and the positive impact of respective central banks’ tightening measures), the Russian ruble (RUB) has continued to underperform markedly. In fact, RUB has been the worst-performing major EM currency year-to-date though some frontier currencies did worse, i.e. the Ukrainian hryvnia (UAH). This may seem anomalous given its twin surplus (current account and budget balance). But, as noted, the trading environment is changing.

Russian ruble: evidence of differentiation

Things have indeed changed in Russia. What used to be a material current account surplus is now shrinking; falling from 18% of GDP in 2000 to 2.9% currently (Figure 6). Moreover, compared to the wider trend in the Central and Eastern European (CEE) region (and the euro area), Russian inflation has remained persistently high (Figure 7): it is well above the target, with the central bank not showing, until very recently, any signs of potential hawkish bias. Indeed, persistently high inflation has driven the material overvaluation of the currency. As Figure 8 shows, RUB is the most expensive currency in real terms within the CEEMEA region. Moreover, and unlike its CEE peers, Russian data has been disappointing of late. Growth decelerated in Q4, while the forward looking Purchasing Managers’ Index (PMI) remains in contractionary territory. All this is further exaggerated by a lower amount of intervention in the FX market by the Central Bank of Russia (CBR), as it moves away from active management of the exchange rate (to allow the currency to float freely next year). Although the Ukraine political crisis may have also added to negative RUB sentiment, it is unlikely to have accounted for much of RUB underperformance so far. As Figure 9 depicts, RUB’s sensitivity to Ukraine asset prices has not been particularly high and has not changed materially since the onset of the crisis. However, should Russia’s involvement become more meaningful, this is unlikely to bode well for RUB (indeed, the currency weakened following news that President Putin ordered troops to combat-readiness in late February).

Figure 8: RUB is the most expensive currency in CEEMEA and Figure 9: RUB not overly correlated with Ukraine assets

Given the challenging growth outlook and still rich long-term valuation, we remain cautious on RUB. That said, the currently overly negative sentiment around RUB, and a rising risk of monetary tightening (either rate hikes or liquidity squeeze if a weaker RUB feeds into higher inflation) may limit material RUB downside from here. Within the CEEMEA space, we prefer the Polish zloty (PLN) over the medium-term, due to its better growth outlook. Poland has exhibited the most balanced mix of growth in the CEE region, stemming from both domestic consumption and exports, and it has a more attractive valuation. We would buy the currency on dips against the euro (EUR) or Czech koruna (CZK).


The outlook for EM fixed income and FX has improved over the past few quarters. Valuations have adjusted and local assets look less exposed to external factors than was the case in H2 2013. However, challenges remain, and, given a backdrop of downside risks to EM FX, we retain an underweight allocation to EM bonds. We still prefer hard currency debt over local – both offer similar levels of yields, but exhibit different levels of risk. For EM FX, we retain a cautious stance. Although valuations have adjusted, EM FX is not cheap in general.

Are EM currencies still vulnerable to external risks from US monetary policy?

Although we have observed a shift in the drivers of EM assets (from external factors to domestic), we are certainly not complacent with regard to external risks. In particular, we see the potential for the market to price in earlier rate hikes by the Fed as a material downside risk to EM assets, just as it is a key upside risk to our USD view. This is because the consequent volatility and increases in short-end US rates have the potential to cause another wave of negative sentiment towards EM assets.

Although comparisons could be made with last summer, when the market began to reprice its outlook for QE tapering, leading to a severe EM sell-off, we would note one difference. While the QE taper debate came out of the blue, surprising the market, the situation now seems different, as investors have an eye on an eventual rise in the US Fed Funds rate (though expectations with regard to the timing of such rate hikes differ). As a consequence, any adverse reaction to developments in US monetary policy might be somewhat less severe than was the case in 2013.