Forex Blog: Currency Trading News & Analysis.

June 25th 2009

Emerging Market Currencies Witness “Correction” as Risk Aversion Rises

Since peaking in the beginning of June, the MSCI emerging markets index has fallen nearly 10%. While this is small potatoes compared to the 60% rise that the index cranked out in the previous three months, it could signal the beginning of a “correction.”

msci-rises

Around the peak a couple weeks ago, the Forex Blog reported that emerging market stocks had become quite expensive, relative to historical P/E ratios. It’s hard to say whether investors were/are operating under similar assumptions when the market pulled back, or rather if they have been driven by other factors. This is because emerging market currencies, like many other asset classes, have experienced a disconnect from fundamentals of late, such that the ebb and flow of risk aversion – rather than any substantive developments – now dictates the movement of asset prices.

Analysts looking for clues into why specific currencies were rising against the Dollar ignored the fact that virtually all currencies were rising, albeit some more than others. In other words, it was a Dollar-negative story as much as it was an emerging markets story. Likewise, risky investments are losing value across the board now that risk aversion is back in fashion, not because of a perceived change in emerging markets growth potential.

Still, there is much to be nervous about. Latvia still hasn’t dealt with its currency, which some experts think needs to be devalued by as much as 50%. Turkey has yet to sign a loan agreement with the IMF. Russia’s benchmark stock index fell 20% in one day. One of the best proxies for risk levels are credit default swaps, which function like insurance on bonds. If a company/country were to default on its bonds, a holder of a credit default swap contract would be compensated by the writer of the contract. Suffice it to say that credit default swap premiums, especially on emerging market debt instruments, are once again rising, as investors become more worried about the possibility of default.

Generally, the Yen is viewed as one of the most viable currencies during periods of heightened risk aversion. So is the Dollar for that matter, but the Yen has less baggage, vis-a-vis quantitative easing, etc. Sure enough, the Yen has pulled back tightly of late, rising almost 3% in one day against the Euro alone. [In the current market environment, I think it makes more sense to compare the yen with the Euro, since the two currencies are viewed as fulfilling different purposes for currency traders. The US Dollar, in contrast, is currently being driven by some of the same themes as the Yen, which can make it difficult to use this pair to distill changes in risk appetite.]

euro-falls-against-yen

In short, as the global economy reaches a critical phase in the recession, investors will be looking for confirmation, either that a recovery is nearby or still far away. Right now, the consensus seems to have swayed towards the “recovery is faraway” side. However, a sudden uptick in a widely-watched economic indicator could send the pendulum swinging right back in the opposite direction.

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Posted by Adam Kritzer | in Emerging Currencies, News | No Comments »

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