Executive Summary

  • As the COVID-19 virus intensifies, demand for the U.S. dollar has increased significantly.

    Safe haven flows have contributed to the greenback strength, but a lack of dollar liquidity has also pushed the dollar higher against all G10 currencies, while emerging currencies have come under the most pressure.

  • The rapid depreciation in emerging currencies is becoming concerning as corporates across emerging markets have accumulated a notable amount of debt denominated in U.S. dollars.

    As of the end of Q3-2019, USD denominated debt sitting on EM corporate balance sheets is the highest it has ever been.

  • As emerging currencies continue to depreciate, USD debt repayment capacity is being eroded.

    A stronger U.S. dollar, coupled with dollar funding strains and rising sovereign dollar bond yields, could present challenges for EM corporates if they need to refinance existing debt and should corporates find refinancing difficult, it could place additional stress on emerging economies going forward.

 

King Dollar Rules Again

Throughout the course of the year, the COVID-19 virus has intensified, with over 395,000 confirmed cases globally and over 17,000 fatalities associated with the virus. As the virus has intensified and the forecasted impact on the global economy has gotten worse, volatility within financial markets has skyrocketed. Global equities continue to come under extreme pressure, while riskier assets continue to be sold. With the risk-off tone permeating global markets, the U.S. dollar has strengthened broadly against both G10 and emerging currencies. As of now, the U.S. dollar index (DXY) is up close to 6% this year, while the Advanced Foreign Economies dollar index is about 7.5% higher.

There are multiple factors that have contributed to U.S. dollars outperformance, but we will choose to focus on just two. The first is the dollar's status as a safe haven currency. In times of stress and elevated volatility in financial markets, the U.S. dollar is typically one of the safe haven currencies of choice for market participants. Over the course of the current downturn, the safe haven status of the U.S. dollar has broadly held up, and as of now, the greenback is one of the few currencies to benefit from the recent turmoil in financial markets.

The second contributing factor to greenback strength, and perhaps the most influential over the path of the dollar right now, has been a severe lack of dollar liquidity. One of the indicators we look at to gauge dollar liquidity is cross-currency basis, which is essentially a premium investors pay to get access to dollars. As the cross-currency basis becomes more negative, it is more expensive for investors to gain access to dollars and is a signal that a shortage of U.S. dollars is becoming more severe. Over the last few months, we have seen cross-currency basis for major G10 currencies such as the Canadian dollar, Japanese yen and euro turn sharply negative, approaching levels not seen since the financial crisis of 2008-2009 and the peak of the European sovereign debt crisis in 2011.

As a result of the dollar's safe haven status and lack of dollar liquidity, foreign currencies across the G10 spectrum have all sold-off. In this context, the Norwegian krone leads G10 currencies lower, down over 21% as oil prices have collapsed and Norges Bank has turned to aggressive easing of monetary policy. In addition, the Australian and New Zealand dollars are under pressure as a result of the broad sell-off in risk-sensitive currencies and significant monetary easing from the RBA and RBNZ, while the Canadian dollar is weaker as the dual shock of lower oil prices and policy rate cuts weigh on the Canadian dollar. Even the Japanese yen, another typical safe haven currency, has depreciated this year as dollar funding constraints placed downward pressure on the currency.

Emerging currencies in particular have come under the most stress, with the JPMorgan Emerging Currency Index down around 13% so far this year. More specifically, high beta currencies such as the Mexican peso, Russian ruble, South African rand and Brazilian real are down over 20%, while other emerging currencies like the Colombian peso, Indonesian rupiah and Chilean peso have also come under pressure. Sentiment has broadly turned negative towards emerging currencies, while many central banks in emerging countries have cut policy rates significantly in an effort to offset the negative economic impact of the virus. As of now, it is difficult to see what reverses this trend and helps emerging currencies strengthen over the short to medium-term, while the longerterm outlook is becoming even cloudier.

 

EM Corporates Coming Into the COVID Crosshairs

Weaker currencies can present numerous challenges for emerging market economies, although one potential issue we are paying particular attention to is the amount of U.S. dollar denominated debt obligations of corporates in emerging economies. Q3-2019 data from the Institute of International Finance (IIF) indicates dollar denominated debt on EM corporate balance sheets is the highest it has ever been, a little over three trillion U.S. dollars. In addition, EM corporates have taken on more USD debt as a percent of GDP as well, with corporates in almost every emerging country we analyze more USD indebted than during the financial crisis of 2008-2009.

Source: Institute of International Finance, Bloomberg LP and Wells Fargo Securities

Elevated amounts of USD debt in the emerging world is not all that surprising as yields remained low as a result of significant monetary easing from the Fed post-financial crisis and as the U.S. dollar was relatively weak. Once the Fed suggested it would begin normalizing monetary policy in mid-2013 (i.e., Taper Tantrum), the dollar began to strengthen and the issuance of dollar denominated debt from EM corporates began to slow. However, given the sharp sell-off in many emerging currencies, the ability for many of these corporations to repay U.S. dollar-denominated debts could be starting to erode as these repayments are becoming more expensive as local currencies depreciate.

One potential solution for EM corporates could be to refinance their existing debt profile; however, in our view, refinancing outstanding USD debts may be quite challenging. Amid the risk-off tone in global markets, currencies haven't been the only emerging market asset class to come under pressure. Sovereign bonds of emerging countries have also experienced significant selling pressure as market participants look to de-risk amid the impact of the COVID-19 virus. Yields of many emerging market sovereigns have spiked recently, and despite having less currency risk than local currency debt, USD yields have still risen significantly. With bond yields elevated, the refinancing is becoming more expensive and could put EM corporates in a difficult position when making financing decisions.

 

Economies Risk a Sharper Downturn

Looking ahead, we believe the current dynamics that are resulting in a surging U.S. dollar and higher emerging market sovereign yields are likely to continue over the short- to medium-term. Volatility is likely to stay elevated which should push yields higher and attract safe haven flows to the U.S. dollar, while dollar liquidity is likely to remain low, which should also result in dollar strength against most emerging currencies. Should the greenback continue to strengthen the way we currently forecast, emerging currencies are likely to stay under pressure for an extended period of time and it is possible that highly indebted countries could run into a situation where multiple corporates have difficulty paying debts. If a scenario materializes where numerous EM corporates have issues repaying debts, it is possible that multiple economies could experience stress on their respective financial systems and banking sectors, which in turn could lead to additional pressure on economies throughout the emerging world.

On the other hand, it is possible that the COVID-19 virus gets contained more quickly than expected and investor sentiment improves. In addition, central banks could find additional ways to free up dollar liquidity. The Fed's FX swap lines that have been announced should help with the lack of dollar liquidity, but authorities could conceivably extend these to additional central banks and provide even more access to U.S. dollars.

 

Download The Full Special Commentary

Recently, the stock market has experienced high levels of volatility. If you are thinking about participating in fast moving markets, please take the time to read the information below. Wells Fargo Investments, LLC will not be restricting trading on fast moving securities, but you should understand that there can be significant additional risks to trading in a fast market. We've tried to outline the issues so you can better understand the potential risks. If you're unsure about the risks of a fast market and how they may affect a particular trade you've considering, you may want to place your trade through a phone agent at 1-800-TRADERS. The agent can explain the difference between market and limit orders and answer any questions you may have about trading in volatile markets. Higher Margin Maintenance Requirements on Volatile Issues The wide swings in intra-day trading have also necessitated higher margin maintenance requirements for certain stocks, specifically Internet, e-commerce and high-tech issues. Due to their high volatility, some of these stocks will have an initial and a maintenance requirement of up to 70%. Stocks are added to this list daily based on market conditions. Please call 1-800-TRADERS to check whether a particular stock has a higher margin maintenance requirement. Please note: this higher margin requirement applies to both new purchases and current holdings. A change in the margin requirement for a current holding may result in a margin maintenance call on your account. Fast Markets A fast market is characterized by heavy trading and highly volatile prices. These markets are often the result of an imbalance of trade orders, for example: all "buys" and no "sells." Many kinds of events can trigger a fast market, for example a highly anticipated Initial Public Offering (IPO), an important company news announcement or an analyst recommendation. Remember, fast market conditions can affect your trades regardless of whether they are placed with an agent, over the internet or on a touch tone telephone system. In Fast Markets service response and account access times may vary due to market conditions, systems performance, and other factors. Potential Risks in a Fast Market "Real-time" Price Quotes May Not be Accurate Prices and trades move so quickly in a fast market that there can be significant price differences between the quotes you receive one moment and the next. Even "real-time quotes" can be far behind what is currently happening in the market. The size of a quote, meaning the number of shares available at a particular price, may change just as quickly. A real-time quote for a fast moving stock may be more indicative of what has already occurred in the market rather than the price you will receive. Your Execution Price and Orders Ahead In a fast market, orders are submitted to market makers and specialists at such a rapid pace, that a backlog builds up which can create significant delays. Market makers may execute orders manually or reduce size guarantees during periods of volatility. When you place a market order, your order is executed on a first-come first-serve basis. This means if there are orders ahead of yours, those orders will be executed first. The execution of orders ahead of yours can significantly affect your execution price. Your submitted market order cannot be changed or cancelled once the stock begins trading. Initial Public Offerings may be Volatile IPOs for some internet, e-commerce and high tech issues may be particularly volatile as they begin to trade in the secondary market. Customers should be aware that market orders for these new public companies are executed at the current market price, not the initial offering price. Market orders are executed fully and promptly, without regard to price and in a fast market this may result in an execution significantly different from the current price quoted for that security. Using a limit order can limit your risk of receiving an unexpected execution price. Large Orders in Fast Markets Large orders are often filled in smaller blocks. An order for 10,000 shares will sometimes be executed in two blocks of 5,000 shares each. In a fast market, when you place an order for 10,000 shares and the real-time market quote indicates there are 15,000 shares at 5, you would expect your order to execute at 5. In a fast market, with a backlog of orders, a real-time quote may not reflect the state of the market at the time your order is received by the market maker or specialist. Once the order is received, it is executed at the best prices available, depending on how many shares are offered at each price. Volatile markets may cause the market maker to reduce the size of guarantees. This could result in your large order being filled in unexpected smaller blocks and at significantly different prices. For example: an order for 10,000 shares could be filled as 2,500 shares at 5 and 7,500 shares at 10, even though you received a real-time quote indicating that 15,000 shares were available at 5. In this example, the market moved significantly from the time the "real-time" market quote was received and when the order was submitted. Online Trading and Duplicate Orders Because fast markets can cause significant delays in the execution of a trade, you may be tempted to cancel and resubmit your order. Please consider these delays before canceling or changing your market order, and then resubmitting it. There is a chance that your order may have already been executed, but due to delays at the exchange, not yet reported. When you cancel or change and then resubmit a market order in a fast market, you run the risk of having duplicate orders executed. Limit Orders Can Limit Risk A limit order establishes a "buy price" at the maximum you're willing to pay, or a "sell price" at the lowest you are willing to receive. Placing limit orders instead of market orders can reduce your risk of receiving an unexpected execution price. A limit order does not guarantee your order will be executed -" however, it does guarantee you will not pay a higher price than you expected. Telephone and Online Access During Volatile Markets During times of high market volatility, customers may experience delays with the Wells Fargo Online Brokerage web site or longer wait times when calling 1-800-TRADERS. It is possible that losses may be suffered due to difficulty in accessing accounts due to high internet traffic or extended wait times to speak to a telephone agent. Freeriding is Prohibited Freeriding is when you buy a security low and sell it high, during the same trading day, but use the proceeds of its sale to pay for the original purchase of the security. There is no prohibition against day trading, however you must avoid freeriding. To avoid freeriding, the funds for the original purchase of the security must come from a source other than the sale of the security. Freeriding violates Regulation T of the Federal Reserve Board concerning the extension of credit by the broker-dealer (Wells Fargo Investments, LLC) to its customers. The penalty requires that the customer's account be frozen for 90 days. Stop and Stop Limit Orders A stop is an order that becomes a market order once the security has traded through the stop price chosen. You are guaranteed to get an execution. For example, you place an order to buy at a stop of $50 which is above the current price of $45. If the price of the stock moves to or above the $50 stop price, the order becomes a market order and will execute at the current market price. Your trade will be executed above, below or at the $50 stop price. In a fast market, the execution price could be drastically different than the stop price. A "sell stop" is very similar. You own a stock with a current market price of $70 a share. You place a sell stop at $67. If the stock drops to $67 or less, the trade becomes a market order and your trade will be executed above, below or at the $67 stop price. In a fast market, the execution price could be drastically different than the stop price. A stop limit has two major differences from a stop order. With a stop limit, you are not guaranteed to get an execution. If you do get an execution on your trade, you are guaranteed to get your limit price or better. For example, you place an order to sell stock you own at a stop limit of $67. If the stock drops to $67 or less, the trade becomes a limit order and your trade will only be executed at $67 or better. Glossary All or None (AON) A stipulation of a buy or sell order which instructs the broker to either fill the whole order or don't fill it at all; but in the latter case, don't cancel it, as the broker would if the order were filled or killed. Day Order A buy or sell order that automatically expires if it is not executed during that trading session. Fill or Kill An order placed that must immediately be filled in its entirety or, if this is not possible, totally canceled. Good Til Canceled (GTC) An order to buy or sell which remains in effect until it is either executed or canceled (WellsTrade® accounts have set a limit of 60 days, after which we will automatically cancel the order). Immediate or Cancel An order condition that requires all or part of an order to be executed immediately. The part of the order that cannot be executed immediately is canceled. Limit Order An order to buy or sell a stated quantity of a security at a specified price or at a better price (higher for sales or lower for purchases). Maintenance Call A call from a broker demanding the deposit of cash or marginable securities to satisfy Regulation T requirements and/or the House Maintenance Requirement. This may happen when the customer's margin account balance falls below the minimum requirements due to market fluctuations or other activity. Margin Requirement Minimum amount that a client must deposit in the form of cash or eligible securities in a margin account as spelled out in Regulation T of the Federal Reserve Board. Reg. T requires a minimum of $2,000 or 50% of the purchase price of eligible securities bought on margin or 50% of the proceeds of short sales. Market Makers NASD member firms that buy and sell NASDAQ securities, at prices they display in NASDAQ, for their own account. There are currently over 500 firms that act as NASDAQ Market Makers. One of the major differences between the NASDAQ Stock Market and other major markets in the U.S. is NASDAQ's structure of competing Market Makers. Each Market Maker competes for customer order flow by displaying buy and sell quotations for a guaranteed number of shares. Once an order is received, the Market Maker will immediately purchase for or sell from its own inventory, or seek the other side of the trade until it is executed, often in a matter of seconds. Market Order An order to buy or sell a stated amount of a security at the best price available at the time the order is received in the trading marketplace. Specialists Specialist firms are those securities firms which hold seats on national securities exchanges and are charged with maintaining orderly markets in the securities in which they have exclusive franchises. They buy securities from investors who want to sell and sell when investors want to buy. Stop An order that becomes a market order once the security has traded through the designated stop price. Buy stops are entered above the current ask price. If the price moves to or above the stop price, the order becomes a market order and will be executed at the current market price. This price may be higher or lower than the stop price. Sell stops are entered below the current market price. If the price moves to or below the stop price, the order becomes a market order and will be executed at the current market price. Stop Limit An order that becomes a limit order once the security trades at the designated stop price. A stop limit order instructs a broker to buy or sell at a specific price or better, but only after a given stop price has been reached or passed. It is a combination of a stop order and a limit order. These articles are for information and education purposes only. You will need to evaluate the merits and risks associated with relying on any information provided. Although this article may provide information relating to approaches to investing or types of securities and investments you might buy or sell, Wells Fargo and its affiliates are not providing investment recommendations, advice, or endorsements. Data have been obtained from what are considered to be reliable sources; however, their accuracy, completeness, or reliability cannot be guaranteed. Wells Fargo makes no warranties and bears no liability for your use of this information. The information made available to you is not intended, and should not be construed as legal, tax, or investment advice, or a legal opinion.

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