- One group finds solace only in USD denominated risk-free and investment-grade assets
- The second group feels the USD past its peak, with EMFX and local rates primed for outperformance
- Some high frequency traders saw tightening USD liquidity affecting financial stability
- We know that the Fed and Treasury are working to keep US payments and settlements orderly
- But that still leaves risk on the table for EM
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Commentary: What we’re hearing from clients
As the year draws to an end, we have been busy preparing our year-ahead outlook (to be published on December 5) and doing a final round of meetings with our institutional and wealth clients around the world.
Long-only investors have had, unsurprisingly, a difficult year. Regardless of ratings or asset class or valuation, this has been a year of the short rates and short equities strategy. Macro relative value traders have done well, especially in the currency space. Being long the US dollar has paid off handsomely; the other successful trade was being long commodities. Beyond that, investors in equities and fixed income have had a torrid year. Advanced versus emerging market diversification have not helped either.
In contrast to earlier this year, when uncertainty around inflation was too large of have strong convictions, views have now hardened, but not one point. Rather, they have diverged in two opposite directions:
One group finds solace only in USD denominated risk-free and investment-grade assets, considering the rest of the world likely to be remain characterised by major risks, both at the global macro (high rates, high inflation, slowing demand) and local idiosyncratic levels (war in Ukraine for Europe, zero-Covid for China, etc.). Inflation will come down next year but not enough to warrant rate cuts, and hence pressure on emerging markets would continue, along this line of perspective.
This group also tends to believe China is by and large uninvestable due to attendant restrictions emanating from great power rivalry, and various domestic developments, from property sector distress to tech regulation.
The second group is convinced that the USD has peaked, with emerging market currencies and local rates primed for outperformance. This group has a constructive view on China, finding valuations and policy direction attractive.
Among high frequency traders, we have been picking up some concerns about worsening market liquidity and resulting volatility. Several fixed income traders have told us that dollar liquidity tightening has been manifesting in thinning trading volumes. From US treasuries to frontier market bond/credit, getting the asked-for allocation from dealers have become challenging; bid-ask are uncomfortably wide, adding to the cost of trading.
This issue had in fact come up recently in our conversations with several ex-Fed officials. They assured us that the US Fed and the Treasury are working hard to make sure that quantitative tightening does not translate into a liquidity squeeze that threatens financial stability. But these efforts are focused on US markets, not beyond. There is little talk about renewing or extending bilateral dollar liquidity swaps with emerging market central banks, a measure that was very useful in the aftermath of the global financial crisis more than a decade ago. We think that financial stability risks today are less than they were then, given the stronger balance sheets of banks and reduced need for short term financing, but there should be no room for complacency in the higher-for-longer rates environment.
Taimur Baig
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