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The EM/DM Correlation: Who Is Leader And Who Follower

Earlier today, SocGen’s FX strategist Kit Juckes showed an interesting chart which correlate the performance of EM currencies though the eye of the JP Morgan EM FX index, plotted against the performance of the Euro, Australian dollar and Swedish krona.

Juckes made a fascinating observation that while there is clearly a divergence between the broader EM FX index and some notable G-10 pairs, like EURUSD for example, the chart makes it look as through the correlation between SEK and EMFX is almost 100%, and while it may not be that high, the correlation between EM and Australian dollar is a little stronger. Which is why, according to Juckes, despite strong GDP data yesterday, the AUD isn’t finding much love this morning (largely thanks to mortgage rate hikes announced by two of Australia’s largest banks).

By the same token, Juckes notes that the SEK may struggle to rally much even if the Riksbank continues to indicate a rate hike is coming later this year and adds that there are buyers of SEK ahead of this weekend’s election, on the grounds that it won’t change the underlying support of a near-4% current account surplus, and a budget surplus that proves all the ammunition needed to support the economy, but the global backdrop is definitely pulling the other way

In any case, as the SocGen FX strategist notes, “the correlation between higher-beta G10 currencies (AUD and SEK, notably) and EMFX, is striking.”

And while the tightening turn in global monetary policy and in global growth may be slow, but add in disruption to global trade and hyper-sensitivity to previously ignored local weakness, and EMFX is likely to remain under pressure (sorry EM bulls).

As a result, this both feeds off and supports dollar strength – in other words the relationship is largely bidirectional – until one of three things happens:

  1. US domestic markets react (the yen would be the big winner)
  2. The US economic cycle rolls over and we start looking forward to Fed easing (a story for H2 2019 perhaps), or
  3. European politics and growth allow Bund yields to rise and breath some life back into the euro (which will happen eventually, but……).