Why the emerging market currency drop became a rout and when it might end

01/27/2014 3:15 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

A brief survey of the big investment banks’ favorite currency trades as of the end of 2013 shows why the current sell off in emerging market currencies and financial assets has been so violent—and it also gives me a sense that the worst of the damage isn’t that far from being over. (The worst of the damage, in this case, means that emerging markets may stop plunging on fear; it doesn’t mean that emerging markets are about to stage a recovery. The fundamentals from China to Brazil remain sufficiently negative to keep the downward bias intact for most emerging markets. But I can see that downward trend turning into something less severe on a day to day basis than the 1.9% drop in the MSCI Emerging Markets Index as of 2 p.m. New York time today.)

Here’s a sampling put together by Bloomberg of end of 2013 best currency trading ideas from the big banks:

November 24 Bank of America picked long Mexican peso and short Japanese yen. The peso would climb to 8.4 yen, Bank of America forecast. Last week the peso fell 3.5% to 7.6 yen.

In December Danske Bank, Denmark’s largest bank, recommended buying Turkish lira and selling Danish krone as one of its 10 best ideas for 2014.

Societe Generale had put on a trade buying South African rand and selling Hungarian forints.

A few things pop out at me from these and other examples.

First, there was a lot of money at the end of 2013 that was willing to bet on emerging market currencies picking up strength in 2014.

Second, a large number of these trades have been reversed in the last two weeks. Societe Generale closed its rand/forint trade on January 16 after losing 1.2% in two weeks. Danske Bank ended its lira/krone trade by January 2 after Turkey’s current corruption scandal escalated.

And third, the size of the moves in currency markets have taken trading desks by surprise since they have been so much greater than historical volatility. Drops in the rand and Turkish lira were 2.5 times the normal trading range, Bloomberg calculates. The greater than expected size and speed of these drops led trading desks to rush to close out their trades before the damage got worse—which, of course, made the damage get worse. This isn’t to say that this most recent drop is unprecedented in emerging market currencies—Bloomberg’s emerging market currency index shows a 2.7% drop in this rout, but that index fell 3.7% in May 2013. I doubt that’s comforting, however, since all it really demonstrates is that selling now makes sense given the record of even bigger drops in these currencies.

All this closing out of trades is actually a good sign. Once currency traders are back in cash and once they’ve licked their wounds, they’ll start sifting through the wreckage to see if they can find new trades to put on to recoup some of these losses. The most common theme I’m hearing now is to go long the currencies of exporters such as Korea (won) and Mexico (peso.)

Money flowing in those directions wouldn’t end the downward pressure on the currencies of countries with big current account deficits—Brazil, South Africa,Turkey, India, and Indonesia to name a few. But it would be enough to turn indiscriminate selling into discriminate selling.

At that point, I’d be willing to do some bargain hunting in selected emerging markets. (And in Japan after more traders cover their yen shorts.)

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