Summer Love-in for Yen, Emerging Markets Won't Last, BofAML Says

(Bloomberg) -- In an unusual turn of events, investors are long in emerging-market currencies as well as the Japanese yen.

Bank of America Merrill Lynch doesn’t expect the trend to last. The yen will probably weaken and developing-nation currencies turn more mixed later this year as the Federal Reserve tightens policy and U.S. tax reform comes through. In the unlikely event of a risk-off correction over summer, the yen and emerging-market currencies will diverge, with the former gaining and the latter weakening, according to strategists Athanasios Vamvakidis and David Hauner.

“EM and JPY are likely to diverge in both good and bad case scenarios,” Vamvakidis and Hauner wrote in a May 18 note. “We expect it most likely to happen after the summer, as monetary policies diverge and a number of risk events could increase market volatility.”

The yen has risen 5.4 percent against the dollar this year, while 18 of the 24 emerging market currencies tracked by Bloomberg have seen gains, from a 12 percent advance for the Polish zloty to the 4 percent gain in the Malaysian ringgit.

Factors that could change the risk appetite later this year include Fed hikes, President Donald Trump’s tax reform, the tapering of quantitative easing in Europe, German elections and Brexit negotiations, the strategists said.

“Some of these events will trigger the divergence between the market’s long EM and JPY positions,” Vamvakidis and Hauner wrote. “The Fed is almost fully priced for the short term, but we believe it is underpriced for the medium and long term.”

Nearer term, there aren’t any major risks apart from the unpredictable North Korea, so volatility should remain low and risk assets supported over the next few months, the strategists wrote.

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Long positions have built up in emerging-market currencies as economic data exceed expectations in most of the world, inflation is picking up but remains under control, earnings are strong, and volatility and financial stress indicators have collapsed, they said. Also, Trump hasn’t scared markets, Brexit hasn’t affected the U.K. economy, and France avoided “sailing into the dark unknown,” according to the note.

Still, the prospect of tightening by major central banks is less positive for developing markets. Against this backdrop, the yen should weaken. So why are investors buying?

Vamvakidis and Hauner offer three explanations, all of which suggest a correction looms later this year: 

• The market is only pricing a slow rate hike path for the Fed, with a couple this year followed by one in 2018, whereas BofAML expects two more this year and three in 2018.
• There’s low consensus hopes for U.S. tax reform, when progress will probably happen before the year end, which would support the American economy with fiscal stimulus and boost markets 
• The market isn’t listening to the Bank of Japan, which will want to maintain its yield-targeting policy even as the Fed and European Central Bank move in the opposite direction. This should see the yen weaken against the euro and dollar.
• “We expect divergence between EM FX and JPY to be driven by monetary policy divergence,” Vamvakidis and Hauner wrote. “This is why we are long EUR and USD against JPY and selective in EM FX with outright longs in our recommendations now limited to the EUR proxies in CEE.”

To contact the reporter on this story: Will Davies in Hong Kong at wdavies13@bloomberg.net.

To contact the editors responsible for this story: Christopher Anstey at canstey@bloomberg.net, Tomoko Yamazaki, Tan Hwee Ann