Global Investing

Indonesia has just given the go-ahead for another leg down in the rupiah. It has cut its forecasts for the exchange rate to 9,700 per dollar compared to the 9,200 level at which the central bank used to step in. The currency has duly weakened and nervous foreigners have rushed to hedge exposure — 3-month NDFs price the rupiah at almost 10,000 to the dollar. The  rupiah last week hit a three-year low, its weakness coming on top of a dismal 2012 which saw it fall 6 percent as the current account deficit worsened. Traders in Jakarta are reporting dollar hoarding by exporters.

All that is spooking foreigners who own more than 30 percent of the domestic bond market. The currency weakness hit them hard last year as Indonesian bonds returned just 6 percent, a third of the sector’s 16 percent average (see graphic).

The central bank does not seem perturbed by the currency weakness. Luckily for it, inflation rates are still benign, which means a weak currency will probably remain in favour.

The big question is how will investors react?

A test will come on Tuesday, when the government will try to raise $724 million via an auction of domestic bonds and T-bills.  There has been some flight by bond investors in recent days  but most have stayed put – after all they are earning a 5-6 percent carry on bonds and currency exposure can be hedged.  Above all, people are betting the central bank is capable of stemming any big falls in the currency.  (They are probably right: Deputy Governor Hartadi  Sarwono assured investors last week that if the rupiah weakened too much, the bank would “definitely respond to it via interest rate policy”).  UBS strategist Manik Narain points out the central bank has $112 billion in its coffers while interest rates are at a record low 5.75 percent:

The central bank has a considerable arsenal. They haven’t even started to raise rates yet and if we were to see some monetary tightening, investors will quickly pay attention and come back.  They can also deploy some of their considerable reserves.

Global Investing has written several times about Japanese mom-and-pop investors’  adventures in emerging markets. Most recently, we discussed how the new government’s plan to prod the Bank of Japan into unlimited monetary easing could turn more Japanese into intrepid yield hunters.  Here’s an update.

JP Morgan analysts calculate that EM-dedicated Japanese investment trusts, known as toshin, have seen inflows of $7 billion ever since the U.S. Fed announced its plan to embark on open-ended $40-billion-a-month money printing.  That’s taken their assets under management to $67 billion. And in the week ended Jan 2, Japanese flows to emerging markets amounted to $234 million, they reckon. This should pick up once the yen debasement really gets going — many are expecting a 100 yen per dollar exchange rate by end-2013  (it’s currently at 88).

At present, the lion’s share of Japanese toshin holdings — over $40 billion of it — are in hard currency emerging debt, JP Morgan says (see graphic).

Now that the Fed appears to have dashed any lingering hopes for an imminent QE3, what’s next for emerging markets? Most observers put this year’s stellar performance of emerging bonds, currencies and equities largely down to the various money-printing or cheap money operations in the developed world. That’s kept core government bond yields bumping along near record lows and benefited higher-yielding emerging assets.

Many would add that in any case a solid economic recovery in the United States should be fairly good news for the rest of the world too. Not so, says HSBC. It argues that a better U.S. outlook is not necessarily good news for emerging markets simply because the side effect of economic improvement is a stronger dollar and higher Treasury yields and that’s an environement in which EM assets tend to underperform.

For an example, it looks back to the days between November 2010 and Feb 2011 when signs of improvement in the U.S. economy steepened the U.S. yield curve,  pushing the spread between 2-year/10-year Treasuries almost 100 bps wider.  Flows to emerging markets dipped sharply, the following graph shows:

Graphic evidence from Investec Asset Management (below) highlighting the demise of the carry trade. It shows returns from borrowing low-yielding currencies such as Japanese yen to buy high-yielding ones over the past 7-1/2 years or so.  There has been a roughy 50 percent decline since the end of July.

Merrill Lynch’s monthly poll of fund managers around the world has a bit of a surprise in the small print. More investors now reckon the Japanese yen is overvalued than see it as undervalued. This is the first time this has been the case since Merrill began asking the question, said by staff to be about eight years ago.

It clearly reflects a 13 percent dive in dollar/yen this year and a 24 percent plunge in euro/yen. But does the new view of value suggest that the unwinding of the carry trade is over? Another question from the Merrill poll shows hedge fund deleveraging levelling off.