Europe Main Beneficiary of Flows from Emerging Markets

The US dollar stands at the fulcrum. Investment flows are leaving emerging markets, with currencies from Brazil,India,Indonesia and Mexico being hit the hardest over the last few sessions. The MSCI Emerging Market Index is off 4.5% over the past five sessions and the rout continues.

Falling commodity prices, country specific challenges, as in India, Indonesia, Brazil, and Turkey, coupled with anticipation that the days of low interest rates in the high income countries are largely behind us, is spurring a reversal of fortune for the emerging markets, as an asset class.  Those countries with current account deficits are particularly vulnerable to this switch.

Reports indicate that those funds are not moving to the US, where expectations for Fed tapering next month running high, lifting the 10-year yields to almost 2.90% yesterday. Rather, reports indicate that Europe has been the biggest beneficiary of inflows over the past week or two.   In fact,it may not just be a flow from the emerging markets into Europe, but there also has been an outflow from US fixed income and equity funds too.

It seems to reflect two related forces.  First, is market positioning.  It does appear that many global investors were under weight Europe, preferring US and Japanese equities through much of the first half and into Q3.  Second, this left many investors ill-prepared for the European reflation story, which has gained traction over the past couple of weeks.  

The Bundesbank monthly yesterday, highlight the conditionality around the ECB's forward guidance is typically BBK behavior, and might not have been a significant factor if it were not for market conditions and positions.  Specifically,  the BBK has once again, seemingly gone out of its way, to outflank the ECB.  

Various measures by the ECB in response to the crisis, from SMP to OMT, including Greek aid and its funding gap, bank supervision, and now the forward guidance, the BBK appears to have been consistently overruled (formally or informally).  The BBK does not let it go and accept the compromises as part and parcel of monetary union.  Indeed, the BBK's criticisms of the ECB policies shows monetary union itself is far from complete. 

The euro is leading the charge today.  It is testing resistance in the $1.34 area and a move above $1.3420 clears the air for a move toward $1.35.  It is also being aided today by a disappointing Norwegian GDP figure (0.2% instead of the 0.7% expansion the consensus expected).  

While this is weighing on the Scandi bloc, with the Norwegian krone especially hard hit, official comments have pressured the Antipodean currencies.  The RBA minutes showed officials still dissatisfied with the Australian dollar.  The market has sold the Aussie off, which is off two cents from yesterday's high, while the New Zealand dollar has been tackled by RBNZ Governor Wheeler's comments dampening rate hike speculation that had been being aggressively priced in.  Wheeler also indicated an Oct 1 implementation date for the new (and higher) loan-to-value requirements for mortgage lending.  

Ironically, the sell-off in US Treasuries, which helped precipitate the market developments, are themselves a beneficiary of the increased turmoil.  US 10-year yields have pulled back almost 10 bp from yesterday's high water mark.  

There are no top tier US or Canadian dollar today.  The FOMC minutes to be released tomorrow are the

next important data point on the tapering discussion.  The Jackson Hole confab beginning later this week is unlikely to live up to its recent past record as an important point in Fed communication.