by Ron Leven.
That is the thorny question that the Fed is grappling with on Wednesday 21 September. While there is clearly the possibility of a rate hike, we think it unlikely it will occur at this meeting. Developed country central banks, including the Fed, face an asymmetric risk horizon. There is plenty of ammunition to fight inflation, but, little to do in response to a slide into recession. Although the US economy is approaching full employment, inflation is below target. The pace of growth also remains soft with signs that the momentum is turning down, which could be exasperated by a stronger dollar. Last week’s market downturn and pickup in volatility also provide incentive not to hike. We suspect that caution will prevail and the Fed will stand pat on rates.
The chart below shows that the market has significantly increased its expectations for potential Fed rate hikes since the July meeting. Most of the focus is on the December meeting and beyond with only a marginal 5 basispoints priced in by the November meeting. And even out to next May’s meeting, there is not a full hike (i.e. 25bps) priced in. If the Fed does hike rates today, contrary to our expectations, it will be critical to look at what is priced in for the first half of next year. The impact will be much more significant if the market continues to price for another hike in the first half of next year.
Yield Curve Implied Fed Rate Hikes at Upcoming Meetings
As indicated, if the Fed, as we expects, does not hike today, December is the earliest they can move and there is a significant chance they will stay on hold into the New Year. An extended period of stable rates is typically friendly for putting on carry trades. To determine which currencies offer relatively attractive yield, we filter on emerging market rates in the bubble chart below. The axes in the chart are the historic (vs. the past three years) percentile of 1-year net carry outright and scaled by 1-year implied volatility. Currencies in the upper right corner are attractive on both metrics and the three currencies that stand out as outliers in this corner are COP, MXN and PHP. The bubble size is driven by the outright net-carry itself, BRL and RUB, in particular, offer better carry than the outlier trio. However, relative to where they have traded over the past three years, BRL and RUB are not attractive. At over 6%, COP 1-year net carry is well above the emerging market average. MXN and PHP carry, while lower, are also above the emerging market mean.
Filtering for Relative Value in Emerging Market 1-Year Net Carry
Attractive carry is no guarantee of a positive return as exchange rate may have adverse moves. Hence it is worth considering whether, carry aside, the prospects for COP, MXN or PHP appear positive. The chart on the next page shows the current real trade-weighted exchange rate and the average value over the past decade. The COP real exchange rate is almost 10% below the long-term average, while MXN is roughly 20% below. Both these currencies are significantly undervalued which should make them biased to strengthen in a benign environment. The real PHP, by contrast, is roughly 15% above its long-term average making exposure in this currency much more problematic.
Current and Long-Term Average Real Trade-Weighted Exchange Rate
Balance of payment flows are another key exchange rate driver. The chart above shows the current account as a percent of GDP for the trio of carry-attractive currencies. Colombia stands out on this indicator as its current account has moved into a significant surplus – in excess of 1% of GDP. A current account surplus is important as it makes the country less dependent on foreign capital inflows and, hence, its currency less prone to violent selloff (in response to adverse news or a broad sell-off of high-beta assets). Mexico’s long history of small deficits also suggests that dependency on capital inflows is modest. Again the Philippine currency stands out on the downside as its current account deficit is substantial and growing. Assuming the Fed does not hike, COP and MXN look attractive to buy. Both of these currencies offer above average yield and the underlying exchange rate valuation and current account dynamics work in favor of currency strength. If the Fed does hike, stand aside initially, but look to buy if the market prices out another hike in the first half of next year.