02FX & EM Strategy: When To Fade The Commodity Currency Rally
James Lord
The outperformance of commodity currencies has been a strong theme so far this year and particularly since the Russian invasion of Ukraine. Regionally, this has of course meant that Latin American currencies plus ZAR have been the top performers, with the rest of CEEMEA and Asia struggling. We maintain a bearish bias on Asia but think that the pace of commodity currency outperformance will slow and in some cases is worth fading. We add long PLN/ZAR and long USD/COP. Otherwise, we stay neutral on USD and EM currencies at the index level.
Sell BRAZIL 5Y CDS versus COLOM 5Y CDS: Colombia has clearly lagged Brazil significantly in the past year yet at this point we don’t see what reverses the trend, meaning that we expect Colombia to retrace its recent rebound and to trade wide to Brazil again (Exhibit 27). On the elections, Colombia has a higher chance of seeing a change in its so far orthodox policy framework (see Colombia: Downside Risk Ahead of Election, March 1, 2022). In Brazil, there is certainly room for uncertainty into the elections but the potential outcomes come with less uncertainty.
On fiscals, both look bad yet in terms of financing sources Brazil looks much better insulated due to its reliance on domestic financing. Indeed, for Colombia we increasingly worry about the wide external balances amid tighter global financing conditions. The trade balance is showing little sign of improving despite the high oil prices, largely driven by imports that were up 58%Y in January (Exhibit 26). Colombia should have accessed the external bond market earlier in the year yet now has to still come with at least US$3 billion amid more difficult conditions and higher yields. Brazil may also issue external bonds but is under less pressure. Finally, positioning has also flipped, with EM-dedicated OW to Colombia higher than Brazil for the first time in at least five years (see EM Technical Watch, March 29, 2022).
From current levels of Brazil 5Y CDS trading 17bp wide to Colombia, we target Brazil trading 15bp through Colombia with a stop at 40bp wide. The risk is that spending pressures build in Brazil or that there is a sudden change to a much higher chance of policy continuity in Colombia.
What could finally reverse LatAm’s outperformance? While we think that it is still a bit early to position for broader underperformance across LatAm currencies, there are a few factors that we are currently monitoring.
- Russia/Ukraine de-escalation prospects: We think that more concrete steps towards a peace agreement between Russia and Ukraine could trigger some rotation out of LatAm FX back into CEE FX, especially given significantly more attractive valuations and cleaner positioning in the latter. It can also be argued that de-escalation could trigger a reversal in recent commodity price strength, potentially prompting a shift from commodity exporters (where LatAm stands out) back into commodity importers (see FX & EM Strategy: When to Fade the Commodity Currency Rally for more).
- A dovish shift in LatAm central bank rhetoric: As noted above, three of the five major central banks have recently started to resist market pressures to deliver aggressive hikes, despite ongoing inflationary pressures. The March CPI prints should be an important test for the perceived credibility of these three central banks, particularly as risks remain skewed towards upside surprises, but this shift overall suggests a downward bias for LatAm real rates in the near term. While a bit early, we think that investors might look to rotate out of LatAm FX and into AXJ FX, as the carry profile of the latter should improve once regional central banks start to deliver hikes and the region becomes the last beacon of hawkishness in EM.
- Idiosyncratic developments: While recent price action across LatAm FX has been dominated by global factors, the region’s idiosyncratic narratives should not be disregarded. In Brazil and Colombia, the potential for further election-related volatility and fiscal unorthodoxy remains high, while in Mexico energy reform discussions are coming back into the spotlight. In Chile, the government is preparing to hold the long-awaited constitutional referendum (with some unorthodox proposals on the table), while in Peru political volatility remains elevated. We keep monitoring these factors very closely, as they continue to pose downside risks for the region.
Short COP for now: We think that COP remains extremely exposed to all three factors mentioned above, particularly in light of expensive valuations, an unattractive carry profile and ongoing risks around what could be a highly polarised election, with non-negligible risks of an unorthodox shift. We recently added long USD/COP positions, targeting 3,960 (see Colombia Economics & Fixed Income Strategy – Central Bank Decision: A Suboptimal Reaction, March 31, 2022).
| COP | Dislike: Long USD/COP: We prefer to play a relatively less hawkish BanRep via FX (versus rates), particularly in light of expensive valuations, an unattractive carry profile and ongoing risks around what could be a highly polarised election, with non-negligible risks of an unorthodox shift. | Dislike: Pay 10-year COPxIBR (10k DV01): We extended the target on our 10-year IBR payer to 9.00%, given rising risks around longer-dated UST. While we do expect some mild near-term steepening as the market reduces some of its near-term expectations of an acceleration in pace, we think that expectations for Colombia’s terminal rate should remain elevated (though likely to slide slightly below 9.00%), given the relatively less mature hiking cycle. We do not think that Colombia can afford to adopt the same cautiously dovish stance as other regional peers whose hiking cycles are in significantly more advanced stages. Colombia’s ex ante policy rate is only 0.50%, well below the other cautiously dovish peers. In addition, the country’s extremely wide twin deficits make its local assets relatively more exposed to a hawkish FOMC or to a deterioration in risk appetite. |
Source: CitiFX Strategy
We are also waiting for some central bank rate decisions in PLN, PEN, RON, INR and HUF and Eurogroup’s press conference on the geopolitical conflict. Minutes from recent central bank meetings are expected for USD, HUF, PLN, MXN and COP, while central bank rhetoric should remain hawkish for USD, EUR, and SEK, but dovish for GBP.
· COP: We have Colombia Monetary Policy Minutes at 23:00 BST (Monday). Banrep reached a 5-2 vote in favor a dovish +100bp hike last week (to 5.0% from 4.0%), with the two dissenters voting in line with Citi and market expectations for 150bps. While Citi Economics read the decision as Banrep being comfortable with the current 100bps pace, Banrep left the door open for acceleration if upcoming data makes it necessary, and our economists continue to feel comfortable with their 7.00% terminal rate expectation. Minutes may opine on the balance of risk for hawkish policy going forward, though COP weakness is expected either way on the back of presidential elections.
Colombian policy makers have little appetite to further accelerate the tightening cycle despite higher inflation and evidence of stronger activity. Rather, they are poised to continue gradually increasing rates and slowly reducing monetary accommodation. High uncertainty about the economic outlook and concerns about lingering weakness in the lagging labor market are behind the relatively cautious tone taken at the March meeting. We still believe that discounts in front-end may offer opportunities to pay, and that it’s too early to receive, given that Colombia is not close to the end of the cycle yet.
