ANALYST VIEW - Three key reasons behind EM currency weakness - Morgan Stanley

“Upward moves in USD/EM have gained momentum this week while the increase in FX volatility has put pressure on front-end rates, driving a bear-flattening of local yield curves," Morgan Stanley said in an FX strategy note today.

The analysts reminded that over the last year or so, much of the pressure on EM assets has been tied to increases in external funding costs via higher UST yields. They added, however, that “the most recent bout of weakness has been driven more directly by a deterioration in risk appetite, with the correlation of daily EM currency returns against daily changes in the S&P 500 having risen off the lows. Meanwhile, the continued improvement in US data - most recently in the July ISM reading - has translated into broad USD strength, despite the risk-off environment keeping UST yields relatively stable."

“The dual impact of falling equity markets and strong US data driving broad USD strength has driven USD/EM crosses higher across the board. Weakness in EM currencies would gain further momentum should upward pressure on UST yields start to build."

The analysts think that currencies with heavy long positioning and/or that have seen a significant drop in carry protection on the back of dovish monetary policy may come under the most pressure in the very near term.

The impact of the strengthening USD on the forint is unambiguously indicated also by chart below.

“Political developments with regard to the fighting in eastern Ukraine and related sanctions being imposed by the EU and US have come in and out of market focus but overall remained on a deteriorating path. The next market focus will be on Russia’s next move, with President Putin having instructed the Russian government to prepare retaliatory measures to sanctions imposed on it," MS said.

They noted that the timeline and gravity of the Russian response remains unclear at this stage, but that the path of events is “moving towards escalation in tit-for-tat sanctions rather than resolution is enough to keep us bearish on RUB and the OFZ market."

“With the EUR/USD decline having gained momentum, CEE currencies have struggled versus USD and other EM currencies that trade primarily against USD. There are also reasons for CEE underperformance versus EUR, with part of the deterioration in external risk appetite being driven by rising risks related to Russia and Ukraine."

MS analysts also noted that data in Poland have continued to show signs of slowing down.

“Still, HUF has led the moves weaker, perhaps given the currency’s low level of carry protection and heavier foreign ownership in its local bond market. As such, we have hit the stop on our tactical short PLN/HUF position, with relative changes in policy stance between the NBP and NBH becoming of secondary importance to the external environment and beta. We see more value in looking for PLN and HUF weakness versus EUR for the time being, in respect to the weak external risk environment."

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