Emerging Markets: What has Changed

(from my colleagues Dr. Win Thin and Ilan Solot)

1) The Israeli central bank surprised markets with a 25 bp rate cut

2) Ukrainian President Yanukovych has been ousted and a new government appears to be in place, but uncertainty and tensions continue; hryvnia peg was eliminated

3) Recent yuan weakness is notable, and has investors wondering if a regime change is in the works

4) Brazil’s central bank hiked rates by 25 bp, slowing the pace from 50 bp previously

Over the last week, Egypt (+3.0%), Korea (+2.5%), and India (+2.2%) have outperformed in the EM equity space in local currency terms, while China (-5.8%), Hungary (-3.4%), and Turkey (-2.9%) have underperformed. 

In the EM local currency bond space, Ukraine (10-year yield -122 bp), Brazil (-31 bp), and Hungary (-17 bp) have outperformed over the last week, while India (10-year yield +13 bp), Turkey (+7 bp), and Indonesia (+6 bp) have underperformed.

In the EM FX space, ZAR (+2.3% vs. USD), IDR (+1.3%) and BRL (+1.1%) have outperformed over the last week, while CLP (-1.3% vs. USD), TRY (-1.3%), and RUB (-1.1%) have underperformed.

1) The Israeli central bank surprised markets with a 25 bp rate cut. No move was expected. It noted that inflation has surprised to the downside. Indeed, January inflation was lower than expected at 1.4% y/y, so it gave Bank of Israel leeway to cut again. We also think the strong shekel was a major factor, as they were likely worried about USD/ILS moving back below 3.50. It's worth noting that Israel policy rate troughed at 0.5% back in 2009, so there's not much more room to go here with the rate at 0.75%. 

2) Ukrainian President Yanukovych has been ousted and a new government should be voted in soon, but uncertainty and tensions continue. Russia remains a huge negative risk, as it announced combat-readiness exercises for its troops this week. Tensions are boiling over in Crimea, where pro- and anti-Russian protests turned violent and a pro-Russian group seized the parliamentary building. The IMF has been invited to talk about a program, but the agency is in a difficult position since tough conditionality would be destabilizing. Lastly, the central bank eliminated the hryvnia peg, which saw USD/UAH spike above 11 today. It really had no choice given dwindling foreign reserves. 

3) Recent yuan weakness is notable, and has investors wondering if a regime change is in the works. We do not think so, and believe policymakers are still acting within the existing parameters. We also do not think yuan weakness will destabilize global capital markets, especially given relative stability in the exchange rate over the last two days. While no one should purport to know the intentions of Chinese policymakers, our best guess is that they are trying to inject more two-way volatility into its FX markets. We do not, however, think that a band-widening is imminent. Indeed, ahead of the last two instances of band widening, there was no noticeable increase in two-way FX risk. As such, we believe that the current spike in CNY/CNH volatility argues against a near-term band-widening. 

4) Brazil’s central bank hiked rates by 25 bp, slowing the pace from 50 bp previously. It appears that the combination of recent currency strength, falling price pressures, and a sluggish economy is moving the central bank closer to the end of its tightening. The use of the phrase “continuation” in its accompanying statement suggests potential for one last 25 bp hike to 11% at the April 2 COPOM meeting. Despite her earlier efforts to move Brazil to a low interest rate regime, the SELIC rate of 10.75% is now exactly where it was when Rousseff first took office in January 2011.