FX Outlook. The Rabo FX Vulnerability Heatmap - revisited

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1 Revisiting Currency Vulnerabilities Financial Markets Research Jan Christian Lambregts Lawrence Tapering delayed but vulnerabilities remain Rabo s FX Vulnerability Heatmap previously highlighted INR as the most vulnerable currency but ZAR has now taken its place. We use this framework to identify FX performance in a world where the liquidity tide is ebbing. The are some caveats however is likely to be another year of two halves with speculation of QE tapering and then the act its self remaining crucial to FX direction. Coinciding with Rabobank s yearly global outlook (the so-called Visie publication due for release on November 13), we have decided to this week take another look at our EM FX Vulnerability framework to determine the likely performance of currencies in Taper Talk This year has been one of mixed fortunes for EM FX across the board. Up until Fed Chairman Bernanke s speech on May 22nd when he noted that the Fed might start tapering QE, EM FX currencies were better bid as the global tide of liquidity and diminished tail-risk of a Eurozone break-up caused price action to follow the Great Flotation price dynamic. This saw risky assets better bid as investors hunted for yield across the board. The Great Flotation theme is one of three that we see characterizing market price action while the question of QE tapering in the US continues to dictate general market moves - for more detail on this framework please see the Rabo Rates article. The threat of a reduction in global liquidity changed this Great Flotation dynamic and market direction became less clear. Indeed, the question of when and how quickly the Fed will begin tapering QE is the main driver of price action across markets at present and it is likely to remain the dominant theme for some time to come. We currently see March as the most likely juncture for the first decrease in the pace of asset purchases in the US but we expect that the new Fed Chairperson, Yellen, will take a somewhat cautious approach and that tapering will occur at a relatively slow pace. When it does happen... When tapering does begin we do not expect the same sort of sharp sell-off across EM currencies seen in the aftermath of May 22nd as the initial knee-jerk reaction was exacerbated by the surprise nature of that day. Indeed, the market now knows that tapering is on the horizon and we would argue that the delay to the previously expected start date (October) is a positive for riskier assets as it is now more likely that tapering will not begin before economic data in the US has picked up enough to warrant it. We would argue that this has not happened yet and we highlight the stickiness of the U6 underemployment rate in the US as an example of a still weak underlying labour market. Indeed, we know the new Fed Chairperson, Yellen, watches this measure of unemployment very closely as she has explicitly highlighted this. EM FX is unlikely to undergo the same dramatic moves seen around the middle of this year as QE tapering is now somewhat priced in, but we are quick to note that the ebbing of the global liquidity tide will still have some impact on EM FX and in this respect we expect traditional macro-fundamental characteristics Page 1 of 6

2 Christian Lawrence to become a key factor in dictating currency price action again. Indeed, we even saw this during the May 22nd inspired sell-off with the most vulnerable currencies falling the most. The Rabo FX Vulnerability Heatmap - revisited There are a number of factors that determine how vulnerable a currency is, as we noted when we first produced the Rabo FX Vulnerability Heatmap back in August, but arguably the most important is its current account. Indeed, we think one of the main reasons that EUR has held up so well is its current account surplus. The Rabobank FX Vulnerability Heatmap and League Table shown below (which was first published on 23 rd August ) extends the concept of currency vulnerability beyond just the current account to incorporate other vulnerability factors as well. 1) Rabo FX Vulnerability Framework revisited (initially produced on 23 rd August based on z-scores) Currency Liquidity CA/GDP BB/GDP CPI Volatility FX/GDP ED/GDP CZK HUF PLN TRY ZAR MXN BRL PEN CLP COP THB PHP MYR IDR INR KRW Source: Bloomberg, Rabobank 1) Liquidity (as measured by the BIS Triennial Central Bank Survey) 2) CA/GDP (current account as % GDP) 3) BB/GDP (fiscal strength - budget balance as a % GDP) 4) CPI (inflation - how strong is the store of value of a currency) 5) Volatility (5yr average of 3mth implied volatility) 6) FX/GDP (how well can a central bank defend a currency against weakness measured by net FX reserves) 7) ED/GDP (External debt as a % GDP) Chart 1 shows the break-down of each vulnerability category and how the EM FX world fares on each metric as measured by a relative z-score. Each category is equally weighted which in itself creates some issues as some factors are clearly more important than others. That said, we still think the league table in chart 2 (which summarises the heatmap) provides a good guide to EM FX performance in a world where the Fed is reducing global liquidity. Indeed, a look at chart 4 shows currency performance in the aftermath of initial tapering talk on May 22 nd relative to a currency s position in the Rabo FX Vulnerability League Table and as can be seen, our EM FX framework provided a good guide as to currency performance. We must note a few exceptions to this however and in doing so some additional caveats to our Heatmap. Indeed, although it works as a good basic framework, the lack of weightings for categories does punish some currencies and favour some others somewhat unfairly. A good example of this is HUF which should Page 2 of 6

3 Christian Lawrence Jan Christian Lambregts Lawrence probably stand higher in the League Table as a result of its current account surplus. Another standout is MXN which is particularly interesting in that one area that the currency excels in is actually, counterintuitively, largely responsible for its underperformance in times of EM selling. The category we are referring to is liquidity. MXN has very deep markets that are far more liquid than any other currency within the EM FX universe we are looking at. It is also the only fully deliverable and convertible currency within the LatAm region but because it is such a standout MXN is often used by portfolio managers with LatAm exposure as a proxy for the region. Consequently, it is often sold heavily during bouts of LatAm FX selling despite the fact its underlying fundamentals are relatively robust. Indeed, MXN overshoots regularly to the downside and we view any move in USD/MXN above 13.2 as offering a good opportunity to short the pair. When it comes to Brazil, the liquidity z-score is not a fair reflection of true BRL liquidity as this refers to the spot market. BRL is far more liquid in the non-deliverable forward space and in fact it is this market that drives BRL spot price action. We should also highlight CZK given the recent policy change which sees the Czech National Bank now intervening in the FX spot market to weaken the currency. This action should keep EUR/CZK effectively pegged at around 27 and as such we think the vulnerability of CZK is now much diminished even though there is potential for some downside as the CNB favours a weaker currency. 2) Rabo FX Vulnerability League Table 3) Change in position relative to 23 rd August I KRW MXN MYR THB CLP PHP PEN COP BRL CZK PLN TRY HUF IDR INR ZAR Source: Bloomberg, Rabobank Average FX Vulnerability Z-score 8th Nov Rank Change (from Aug) KRW 1 +1 MXN 2 +3 MYR 3-2 THB 4-1 CLP 5-1 PHP 6 PEN 7 COP 8 +2 BRL 9-1 CZK 10-1 PLN TRY HUF 13-2 IDR 14 INR ZAR 16-1 Summary We expect EM FX to remain at the mercy of Fed policy action over the coming months and during the first half of next year. We think general market price action across asset classes will move between three key themes (Great Flotation QE tapering delayed - EM FX positive, Great Slowtation QE tapering starts but before macro data warrants it EM FX negative, Great Rotation QE tapering starts but after macro data has improved substantially EM reasonably supported but with diverging fortunes on a currency by currency basis). In bouts of EM selling we expect to see greater differentiation between currencies and when the Fed does begin tapering QE this differentiation will increase. Indeed, in the second half of 2014 we expect traditional macroeconomic factors (including some central banks switching to a tightening bias) to become a major driver of currency price action, arguably for the first time in over five years. In terms of our favourite spot FX trade for 2014, we must again highlight short ZAR/MXN at around current levels of This was also our trade recommendation for when the pair stood at around 1.60 and it served us and our clients very well with a spot return so far this year of around 19%! Page 3 of 6

4 Majors NOW 3m 6m 12m EUR/USD USD/JPY GBP/USD USD/CHF USD/CAD AUD/USD NZD/USD USD/NOK USD/SEK Vs. EUR NOW 3m 6m 12m EUR/NOK USD/NOK EUR/SEK USD/SEK EUR/GBP EUR/CHF EUR/JPY EUR/CAD EUR/AUD EUR/NZD CEE NOW 3m 6m 12m EUR/CZK EUR/HUF EUR/PLN EUR/RON EUR/TRY EUR/RUB USD/HUF USD/PLN USD/RUB USD/TRY RUB basket USD/ZAR NOW 3m 6m 12m USD/BRL USD/CLP USD/COP USD/MXN USD/PEN USD/ARS EUR/BRL EUR/MXN NOW 3m 6m 12m USD/ZAR USD/INR EUR/INR EUR/ZAR Page 4 of 6

5 FX Outlook Financial Markets Research Head Jan Lambregts Macro Elwin de Groot EMU Emile Cardon EMU, Switzerland Bas van Geffen EMU Philip Marey US Jane Foley UK Michael Every Asia Robério Costa Brazil Foreign exchange Jane Foley G Christian Lawrence Emerging Markets Fixed income Richard McGuire Lyn Graham-Taylor Credit markets Eddie Clarke Corporates Stephen Queah Corporates Oliver Burrows Financials Ruben van Leeuwen ABS Sophie Boutar ABS Agri Commodity markets Food & Agribusiness Research and Advisory (FAR) Luke Chandler Global Head Luke.Chandler@Rabobank.com Client coverage Wholesale Corporate Clients Martijn Sorber Global Head Martijn.Sorber@Rabobank.com Hans Deusing Netherlands Hans.Deusing@Rabobank.com David Kane Europe David.Kane@Rabobank.com Brandon Ma Asia Brandon.Ma@Rabobank.com Andrew Millett Australia Andrew.Millett@Rabobank.com Neil Williamson North America Neil.Williamson@Rabobank.com Marco Garcia Mexico Marco.Garcia@Rabobank.com Gaston Iroume South America Gaston.Iroume@Rabobank.com Sergio Nakashima Brazil Sergio.Nakashima@Rabobank.com Financial Institutions Eddie Villiers Global Head Eddie.Villiers@Rabobank.com Arjan Brons Benelux Arjan.Brons@Rabobank.com Bill Cole UK, Eire, Scandinavia, M. East Bill.Cole@Rabobank.com Krishna Nayak Germany, Austria, CEE Krishna.Nayak@Rabobank.com Emmanuel Rodriguez Iberia Emmanuel.Rodriguez@Rabobank.com Philippe Macart France, Italy Philippe.Macart@Rabobank.com Mark Melvin Switzerland Mark.Melvin@Rabobank.com Edwin Bernard Asia Edwin.Bernard@Rabobank.com Masanori Matsuda Japan Masanori.Matsuda@Rabobank.com Sarah Lee USA Sarah.Lee@Rabobank.com Simon Jansen Treasury Sales Europe Simon.Jansen@Rabobank.com Capital Markets Rob Eilering ECM Rob. Eilering@Rabobank.com Mark van Binsbergen DCM Mark.van.Binsbergen@Rabobank.com Herald Top DCM Herald.Top@Rabobank.com Othmar ter Waarbeek DCM Othmar.ter.Waarbeek@Rabobank.com Page 5 of 6

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