FX Daily: EM equities markets find new friends

With investors already pricing more than one 25bp hike from the Fed at the March 16th FOMC meeting, it is hard to see that pricing moving too much further ahead of the Fed's meeting next Wednesday. A stable environment for the dollar allows some local stories to win through and that was a key theme in our 2022 FX outlook published last November.

Latest portfolio flow data does suggest there continues to be strong demand for emerging market assets at the start of the year. It looks as though about $15bn has flowed into EM over the last three weeks, roughly in an 80:20 equity: debt mix. Latin American equity markets have been doing especially well - probably on the strong start to the year for commodities as well as signs that China is ready to start firing up its economy after somewhat of a reset last year.

We discuss Brazil below, which like Taiwan and China has received the lion's share of equity inflows to EM. But we also note some other strong equity performances from the likes of Poland, Hungary and Turkey. Additionally, Hungary, South Africa and Thailand appear to have seen some strong inflows to bond markets over recent weeks.

Our baseline view this year has been that the strong dollar story dominates at the start of the year as the Fed resets monetary policy, but a dollar turn towards the end of the year could see a bounce back in selected EM currencies. Recent evidence suggests that trend into EM has started a little earlier than we thought - perhaps on the back of EM investors being very overweight cash and looking to put money to work. As long as these flows are selective, our core dollar calls (stronger against EUR and JPY, especially in 1H22) should be fine. But were e.g. a China re-rating story to build more quickly, headwinds to our dollar bull story could build too.

For today, the US data calendar looks quiet and again the market should remain focused on 4Q US earnings, whether Treasury yields push any further ahead and developments in Ukraine. On that subject, Ukraine 5 year CDS narrowed 100bp yesterday on comments from the Russian Deputy Foreign Minister that he does not see risk of a 'large-scale' war. Yet some mixed messages from President Biden on the subject last night will give investors little confidence in returning to Ukrainian or Russian assets.

For today, DXY could drift in a 95.25-95.75 range.

EUR/USD is drifting in tight ranges and may continue to do so today. For the Eurozone, the highlight will be the release of the December ECB minutes at 1330CET - the meeting at which the ECB outlined plans to wind down asset purchases. Typically these minutes do not prove too controversial and look unlikely to make any case for the ECB to be in a hurry to raise rates. We would like to think that 1.1375/85 resistance can hold EUR/USD intra-day - otherwise, we may be looking at a broadly weaker dollar environment.

Elsewhere we have Norges Bank announcing its policy rate at 10CET. No change is expected n the 0.50% deposit rate today - though it looks like three 25bp hikes are priced by year-end - starting at the March 24th meeting. Starting the tightening cycle today would be a major surprise. Given little is expected today, we doubt EUR/NOK has to rally too much today on an unchanged decision. We continue to favour EUR/NOK at 9.80 end Q1.

Unsurprisingly political risk has not damaged GBP, where the focus remains squarely on whether the BoE hikes 25bp on February 3rd. The market tried to dissect yesterday's testimony from Governor Bailey - especially on the issue of Quantitative Tightening - but the Short-Sterling interest rate strip barely budged.

We continue to favour EUR/GBP drifting to the 0.8270/80 area (UK equities are out-prerforming, probably on the heavier weighting of Materials in FTSE benchmarks) and Cable could drift back to 1.3670 or even 1.3750 if we are over-estimating dollar strength.

Latin currencies (BRL, CLP and PEN) have been the top performers over the last week, with BRL leading the pack. The bounce in commodity prices (and China) is helping, as is the steady dollar and as are very expensive BRL hedging costs - now 10% per annum through the 3 month NDF. These hedging costs look set to go higher in early February when BACEN should be hiking rates by another 150bp to 10.75%.

Additionally, investors seem to have welcomed the news that left-wing Presidential candidate, Lula, has chosen a centrist as his running mate for the elections in October. BRL will likely be very volatile this year - faced by a sharp rise in external borrowing costs and a slow-down in response to the aggressive hiking cycle. We think USD/BRL will be heading into the elections closer to the 5.75/6.00 area. For the short term, investors might favour some BRL carry and drive USD/BRL back to the 5.30/32 area.