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EM risk: still not in the clear

The environment is still one of very loose monetary conditions in the US, high uncertainty over the ability of the White House administration to unlock a greater growth impulse in the US economy, and some degree of tightening in monetary conditions indices (MCIs) in emerging markets.

This continues to generate a squeeze in the US dollar (weaker dollar and looser dollar funding), directly pushing international capital flows into higher-yielding assets, including emerging markets.

We have been tracking MCIs in the whole of EM for many quarters. It is fair to say that the performance of real effective exchange rates in most of the major EMs, together with some reluctance by central bank policymakers to ease monetary policy, is still generating tightness of monetary conditions in EM.

Despite the broad disinflation trend in many important parts of EM, central bank policymakers in EM have been generally cautious in the way they express a more relaxed view on the macroeconomic backdrop.

All in all, this mix of embedded weakness in the dollar and dollar funding (as the supply of dollar credit remains abundant), together with EM central bank rigidity, continues to drive capital towards EM.

On the credit front, the bias of credit flows towards EM continues to generate a gradual trend of US dollar accumulation by EM central banks.

According to our estimates, the basket of major EM economies (ex-China, ex-Saudi) accumulated $50bn-$60bn (FX-adjusted) in the year to date. This is not massive but it underpins the continuation in a cycle of recovery in some of the basic credit metrics, such as FX reserves balance and current account improvement.

However, not everything is rosy in the EM asset cycle. It is not that straightforward.

The markets went through a sizeable moment of relief in core and EM rates, following an extended sell-off over the past couple of weeks. The last batch of developed market inflation prints (US, EUR and UK) pointed at a low probability of inflation upside surprises at the core over the next few months.

So, we still face the following dilemma: output expansion (which supports some withdrawal of central bank stimulus) versus very timid medium-term inflation dynamics.

In a nutshell, we still believe global flows have yet to adjust to the prospect of a synchronised withdrawal of stimulus by developed market central banks over the coming quarters. We are also concerned with the extension of “available duration” in the European markets. Since the announcement of the European Central Bank’s PSPP asset purchase programme, European treasuries have sold more debt with significantly longer duration.

Overall, this makes us particularly concerned with the directionality of flows in European government bonds and rates.

However, we acknowledge the fact that the lack of traction in the medium-term inflation profile remains one stumbling block for any additional hawkishness by the Fed and the ECB, as the central bank consensus tries to gain some room for a gradual tightening in monetary conditions.

In the meantime, we believe it is fair to imagine upside economic surprises in the US may attempt a comeback over the summer (based on the historical performance of the spread between economic surprise indices in the US and Europe), possibly closing the currently wide gap between European and US economic momentum.

If this scenario prevails, it is still difficult for us to envisage an easy path in EM risk, ahead of Fed and ECB meetings in the autumn.

Luis Costa is head of CEEMEA FX strategy at Citi.