Emerging Market Stress – Over With?

After charging down to complacent and tight levels, EM risk pricing came back with a vengeance this year. But as the charts below of EM corporate credit spreads and EM sovereign risk pricing show, a sense of calm or relief has apparently returned to markets. The charts come from the new weekly Global Cross Asset Market Monitor (get in touch for details). A big driver of the relaxation of EM risk pricing has stemmed from the current stall in the US dollar rebound, but I think there are a few reasons why the prospect of further US dollar strength can’t be ruled out.
While positioning is starting to get stretched to the long side, the US dollar still enjoys substantial yield support vs G10 currencies, not to mention further yield support to come as the Fed continues to tighten and Quantitative Tightening introduces another element to the mix. Although you could argue the US dollar looks slightly expensive vs PPP, the habit is for it to overshoot that valuation metric and I believe we are in the process of a major overshoot.

Furthermore, the USDCNY is showing no signs of slowing down, (as a result of policy divergence, relative macro currents, and politics e.g. the trade war). Indeed, if the USDCNY heads above 7 as I believe there is a material risk of it doing so, it could trigger further weakness across EM currencies and catalyze an extended cycle of strength in the US dollar. Should that happen, the charts above will wake up once again…