Emerging market correction 'has further to go'

The US is at the centre of erupting drama across emerging markets this week, with Brazil's and Mexico's stock markets and currencies crashing, India unexpectedly hiking interest rates and Turkey tightening policy for the third time in less than two months.

Brazil's stock market dropped 3% yesterday and was at one point down over 6%, with bond market trading halted as the benchmark three-year bond yield soared past 10%, and the currency fell 3.3% over the week to a two-year low. Mexican assets have also performed badly, with the peso down 2.2% this week to the weakest level in a year.

Turkey meanwhile stopped its currency collapse by tightening policy for the third time in less than two months. The dollar gained on this risk aversion while 10-year US Treasury yields fell five basis points on what analysts said was a "flight to safety".

Friday sees the start of the G7 leaders’ summit in Charlevoix, Canada, where discussions about trade are likely to be more like heated arguments. Last weekend, the G6 finance ministers, as the US did not attend, expressed their “unanimous concern and disappointment” about the tariffs on metal imports that the US imposed recently, issuing a statement calling for “decisive action” to resolve the issue at this weekend’s meeting. The US sanctions on Iran are also likely to be a topic of conversation.

Not unconnected, earlier in the week India hiked interest rates and after its central bank governor urged the US Federal Reserve to hold back on plans to shrink its balance sheet: "If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable."

Analysts at BofA Merrill Lynch on Friday said the correction in emerging market (EM) asset prices "has some room to go" as various factors and investor positioning was not clear yet.

"Global risks and political uncertainty will continue in the driver's seat," Merrill's EM fixed income strategy & economics team said. "Be it driven by higher US rates or by flight to quality, the observed strengthening of the USD versus EM still have room to go."

The strategists said they were tactically long the Argentine peso on an upcoming IMF deal but bearish on the Brazilian real and Mexican peso (MXN), citing risks to growth forecast remain to the downside on commodity price effects. "Presidential elections in Colombia, Mexico and Brazil will likely increase uncertainty this year. We think the MXN will remain volatile on the back of the elections and NAFTA renegotiations." Merrill said it remains cautious on the Turkish lira too.

BRAZIL FACING ECONOMIC, POLITICAL UNCERTAINTY

Brazilian investors sold stocks amid speculation on a possible action by the country's central bank with the locally traded US dollar on the rise and likely to impact inflation, while political uncertainties also weigh on local equities.

"In Brazil, spread sentiment has joined ongoing concerns about the presidential election, the reform efforts under the new administration, and rising fiscal risk," said Pantheon Macroeconomics. "The historically low carry hedge is playing against the BRL, and recent temporary shocks, such as the truckers’ strike and the forced exit of the Petrobras CEO, have added fuel to the fire."

All these factors are offsetting the Central Bank of Brazil's efforts to bring the real under control.

"Further FX intervention, and a hawkish tone to the COPOM's statements, should help to stabilize the BRL," Pantheon said. "But interest rate hikes as early as June 20 are likely if the pressure does not abate. We could even see a 50bp hike, instead of the usual 25bp increase, if the BRL plunges rapidly. Inflation expectations are already rising."

The surge in US yields and the sharp USD rebound since April have also driven poor performance in many emerging market currencies, Mexico in particular as it is also being dogged by concerns about trade with the US under the NAFTA deal, following the recent imposition of tariffs on steel and aluminum products by the White House.

"Trade tensions likely will remain high over the coming weeks, and the MXN and local rates will continue to underperform," Pantheon said, suggesting the likelihood of a further interest rate hike is rising rapidly. "Some US officials are already talking about carrying out separate trade negotiations with Canada and Mexico, adding to the gloomy outlook."

If the NAFTA story doesn't improve, Pantheon is among those thinking Banxico will need to hike on 21 June, a week after the Fed.