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The joy of the USD bulls following the sturdier than anticipated US inflation data yesterday seems to be momentary. Immediately following the publication USD did appreciate only to then nose-dive.
Despite the fact that the inflation data was clearly positive: both the overall rate (+0.5% mom) as well as the core rate (+0.3% mom) clearly surprised to the upside thus confirming the fears or hopes kindled by the labour market report that the Fed might hike interest rates more quickly than expected - the Fed rate expectations rose yesterday (refer above chart).
That means everything is pointing towards rising real interest rates in the US, a fact that should benefit USD. But it doesn’t. Why?
We stay long EM FX in our region but acknowledge several indicators now look stretched. The EM asset class has enjoyed record inflows so far this year.
Cumulative inflows into EM equities and local fixed income stand at +$24.5bn and +$5.0bn, respectively.
EM FX positioning in the JPM Local Markets Client Survey from 25-Jan has risen to the highest OW level since July-2007.
The EM FX risk appetite index, which agglomerates available high-frequency indicators about flow, positioning and market pricing is now 3.28 standard deviations positive, highest in the series history (refer 1st chart).
Finally, EM FX has now performed well despite higher core yields and lower equity prices. Importantly, breakeven inflation contributed to the higher US 10y yields but about half of the move has been driven by real yields (refer 2nd chart).
Historically, higher contribution from real yields tends to be more negative for EM.
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