Short - lasting ECB effect on EMEA currencies

As the European Central Bank today lowered the interest rate on the main refi operations by 10bp to 0.15% and on the depo facility by the same amount to -0.10% offering abundant liquidity to banks, EMEA currencies reacted powerfully. However, it looks as though the effect is vanishing, especially in EMEA currencies with weak carry opportunities. In the end, we see that what matter for EMEA FX rates in the medium term are fundamentals and geopolitical winds.

In Eastern Europe, while they gained against the euro, the Czech koruna, Polish zloty and Hungarian forint were sudden losers against the US dollar as more ‘carry attractive’ currencies gained. The best performers following the ECB’s decision have been currencies such as the Russian rouble and Turkish lira. Tightening monetary policies in Russia and Turkey make the shift from the EUR to these currencies more attractive. While we have seen immediate strengthening of EMEA currencies with large carries, up to 0.65% in the rouble and similar in the South African rand against the USD and even stronger against the EUR, the effect almost vanished within two hours in post-decision trading. A comparable thing happened to Eastern European currencies, which returned to their old levels even more quickly.

Despite several surprises from the ECB, we do not see any significant effect on money base expansion, which could direct additional new liquidity into EMEA assets, for instance. Today’s measures seem to be credit policy tools, not monetary, and increased lending will go to non-financial corporations, though we do not expect this to have a broad effect on financial instruments in emerging markets despite the apparent divergence in monetary policies between the ECB and its peers in EMEA.

Geopolitical risks in the rouble underestimated

Since February 2014, the Russian rouble has been hit by geopolitical woes relating to the Ukrainian crisis, while its main driver has been news headlines on worsening sentiment. Despite significant rate hikes, the Russian currency weakened further and significant strengthening was seen only in early May 2014. The markets began to hope that peaceful negotiations would resolve the escalating situation in Ukraine as the presidential elections in Ukraine approached. For two months de-escalation expectations fortified the rouble by almost 8% against the dual currency basket. However, a full-scale military operation in eastern Ukraine and the increasing probability of possible Russian involvement leave the geopolitical door fully open. Western nations are still ready to implement new sanctions on the Russian economy if the situation deteriorates further.

Russian macro data does not support the rouble either. Recent GDP growth numbers show that economic expansion is slowing further (0.9% y/y in Q1 14 versus 2.0% y/y in Q4 13) and inflation is accelerating (7.6% y/y in May 2014 versus 6.1% y/y in January 2014). Despite hikes in key rates, Russia’s central bank continues to expand the money base, providing generously cheap RUB liquidity to local banks, which invest it further into FX. In our base case scenario, we continue to be bearish on the RUB, expecting a 1% monthly decrease against the dual currency basket.