Forex markets, after EBC eyes on the FED

 
We have revised some of our EM projections lower (COP, MXN, RUB and ZAR) as our risk-bearish FX trading strategy is paying larger dividends than we anticipated early in the year. Leaving short-term relief rallies aside, we expect the EM and commodity-currency block to remain weak. This trading strategy is built on the Fed’s reaction function and Asian data. Next week’s Fed meeting will be the key event. Risky assets are for sale in markets, volatility is high and there are risks that global economic weakness will spill further into the US economy. With only one rate hike priced in for this year, the Fed may find communication difficult without signalling a disappointing ‘one and done’ approach.  

Asia Stays in Focus: The Fed may have to get back ‘ahead of the curve’ to provide a risk-positive signal. Even if they exceed this high bar, the market impact would not last very long, in our view. More important is the pace at which EM and commodity areas deleverage. Locally, real rates have stayed too high to reduce balance sheet pressures. Resulting capital outflows keep the USD bid. 

Staying Risk Averse: Asia needs to show better growth and implicitly higher returns on investment for the USD shortage theme to abate. Trying to prevent capital outflows by keeping real rates high will cure symptoms but not deal with the problem of locally low investment returns. Hence, Asia’s response to its ailing economic performance remains a good reason to run a risk-averse currency portfolio. We do not see the ECB’s dovish statement as a game changer for risk given the bigger picture.  

How We Trade: Given our framework, we stay short AxJ, and commodity currencies NZD and PEN. Beyond the global backdrop, policy concerns keep us negative on TRY and BRL. We take profit on USD/CAD following the hawkish BoC as we see better opportunities in other regions. 

GBP Weakness: Our bear case of 1.30 for GBP/USD by year end is becoming more likely. We analyse the flow dynamics that support our view.  

    
By Morgan Stanley Research Global