It’s “Make-Or-Break Time” And We Could See “A Painful Cleanout”

Did you read “‘A Small Spark’ Could Trigger An EM Correction, But For Now: ‘No Bears Allowed,’” on Monday?

Well if you didn’t, you should. If only because this was the teaser image:

No, but seriously, there’s a lot of chatter these days about how sustainable emerging market ebullience is. As a reminder, EM flows have been solid (to say the least). As Barclays noted a few days ago, “both EM-dedicated bond and equity funds had positive flows in the week ending 19 April marking the fifth consecutive week that both asset classes have experienced inflows.”

The bank continued: “In the current context of persistent flows into EM, lower US Treasury yields should be supportive of EM returns; however, if lower UST yields begin to reflect a broader ‘flight to safety’ against a backdrop of more mixed signals from the latest economic data, an increase in geopolitical tensions, and European election risks, this would be more worrying for EM assets.”

Well, as we also noted on Monday, MSCI’s EM index of currencies against the U.S. dollar was heading for its highest close since 2014 amid the risk-on sentiment.

One person who is a bit concerned is former FX trader Mark Cudmore who notes that at least on a technical basis, it’s “make-or-break time” for EM FX. More below…

Via Bloomberg

I’m structurally bullish on the global economic outlook, but right now I fear emerging market currencies may be set for an imminent pullback. Mexico, South Africa and Turkey are logical places to look for the sentiment shift to start.

• The MSCI Emerging Market Currency Index is trading within 0.3% of its highest level in more than two years. Technically, this is make-or-break time. Either it’s about to enter a new, higher trading range, or it’s due for a healthy correction after a powerful 2017 rally
• Commodities continue to trade poorly, and the divergence with developing-nation currencies has been particularly notable this year. This factor alone doesn’t mean that EM FX must retrace, but it does suggest the sector may be vulnerable if other inputs conspire against it
• The flows into emerging markets have been exceptionally strong in recent months, but the latest ETF data shows that the torrent of cash is slowing
• Developed market rates are now rising again. This will squeeze liquidity for some emerging markets while also paring their positive yield differential. With French election risk receding, investors may take profit in EM to increase exposure to DM
• Trump is again focusing on trade tariffs. Canada has been the latest victim but Mexico — and the peso — may be vulnerable as Nafta comes back on the agenda. Mexican economic data continues to be poor, implying there are further downside risks to sluggish growth
• Yield-chasers have helped the rand recover a large chunk of the losses in the wake of President Zuma’s sacking of his finance minister, but the longer-term theme of a rapidly deteriorating South African economy will soon dominate again
• The Turkish lira has benefited from Erdogan winning his referendum on an executive presidency. But the large current-account deficit remains, and Wednesday’s central bank meeting may remind investors that yields aren’t high enough given runaway inflation
• During the past five years, May has been the worst month, on average, for EM FX. I remain a structural long-term bull on emerging markets, but the next month could see a painful cleanout of complacent positioning