FX Daily: The return of EM Carry may soon hit a glitch

19th May 2014

  • The latest YouGov poll for the European elections shows the historically larger of the parties vying with UKIP on 26%, Labour on 24% and the Conservatives on 23%. (Sunday Times)
  • Despite falling late in the year, with the ensuing better weather, the Easter holidays failed to provide a boost for UK high streets. The paper says the BRC/Springboard’s footfall figure for April show footfall fell by 0.1% overall on a year ago, down on the 1.8% rise in March. (The Independent)
  • With local and European elections looming large at the end of the week, Opposition Labour leader Ed Miliband will use a speech Monday to “promise” significant increases in the UK’s minimum wage. (The FT)
  • BoE Governor Carney warns of risks from the UK housing market. The comments drive home the message that the Bank is prepared to act to head-off any threat to financial stability from the housing sector, though rate hikes remain the last line of defence. (The FT)
  • At least two Chinese nationals have been killed and 100 injured in recent unrest in Vietnam over a Chinese oil rig drilling in disputed waters”, while China moved to evacuate “more than 3,000 of its nationals from Vietnam”(BBC News)
  • Chinese pork prices rebounded around 20% in the past 10 days following the government’s recent intervention to support prices of pork, which is a major component in China’s CPI basket. (China Times)
  • China’s iron ore futures fell sharply at the open, following a 3% drop on Friday in the wake of the latest government rules to tighten up shadow banking. (MNI Market News)
  • Japan March Core Machine Orders rose 19.1% month-on-month, following a -4.6% fall in February and against expectations of 5.8%.

On Sunday, Carney verbalised what everyone had known for months. The UK’s booming housing market is a problem, in Mr. Carney’s words it is “the biggest risk to financial stability and therefore to the durability of the expansion.” The central bank head however reiterated that rate hikes were the last line of defence in fighting a bubbling housing market and macro-prudential rules are the arsenal of weapons the BoE will rely on for now. The June FPC meeting is now in focus, when the committee will report its bi-annual Financial Stability Report.

The “deep, deep structural problems” in the housing market are simple enough, the dangerous combination of a lack of supply compounded by a surge in population growth. Government policies such as the Help to Buy Scheme and Funding for Lending exaggerated the supply-demand imbalance, not correct it. We have to question the impact the BoE’s quantitative easing policy on rapid house price growth, now in double digits in annual terms. QE works by raising a broad range of asset prices and is commonly thought to push capital out of the domestic market. The UK’s version of QE certainly boosted asset prices especially house prices but almost encouraged foreign capital investment in the housing market. Cash buyers and buying directly off plans have been key features of the housing market frenzy. We highlight this dynamic as it contains important lessons for any ECB version of QE.

The rotation back into emerging markets is to some extent based on expectations of ECB QE and we warn of the high levels of complacency evident as investors once again blindly search for yield irrespective of fundamentals. The 4.18% appreciation of the Malaysian ringgit against the dollar since February is in spite of some worrying fundamentals. Markets believe Eurozone Quantitative Easing will push capital out of the domestic economy as the ECB becomes the largest buyer in the market and valuations become expensive, as per the US example. However this isn’t what happened in the UK, which has the more comparable capital and equity markets to the EMU. This is not only a problem for emerging market assets but for the ECB as asset purchases may actually exacerbate capital inflow into the Eurozone and thus a stronger euro. The declines in peripheral yields since Draghi said those three little words “whatever it takes” happened almost in step with a stronger euro. This is one reason why we maintain the ECB won’t go down the quantitative easing route and believe markets face a summer storm once the ECB disappoints and long positions in eurozone peripheral and EM assets are unwound.

The Indian rupee was the best performing emerging market currency over the last week, up 2.74% against the dollar. The announcement of a solid parliamentary majority for the BJP holds the promise of a sea-change for the countries economic performance. Base metals traded higher last week on the anticipation of demand from a country in desperate need of infrastructure. The Sensex index initially surged 4.5% on the announcement but then closing down 0.6% on the day. This underlines the challenges the new government faces. India reports its FY2014 deficit on May 30th and is expected to overshoot its 4.6% target for this year which puts its 2015 target of 4.1% in jeopardy.  The honeymoon period may soon be over for Narenda Modi.