Opportunity in the Currency Market Turmoil

If you think that the American equities markets have been hit hard lately, take a look at some of the emerging markets. The graph below charts the last six months of the Dow Jones Industrial Average, the iShares ETF, EEM, which tracks emerging markets around the world, and EWY, the South Korean ETF from iShares. Many emerging markets have fallen 60% or more over this period. 

Their currencies have also taken a significant hit. The chart below shows the U.S. dollar as measured against developed market currencies over the same period, with EEM and JEM, a basket of emerging market currencies in Asia, Latin America, Europe, the Middle East and Africa.

While the currency hit has been only about a 25% loss, it is about a 45% difference with the U.S. dollar. Also shown are the Mexican peso (FXM) and the Brazilian real (BZF), to show how similar the currency drops have been for all emerging markets. However you look at it, it has been a grim picture.

There are a couple of driving forces that explain the reaction of investors. The first is that everyone is concerned that the slowdown in America and European economies will disproportional affect emerging markets, since the western nations buy much of all EM goods. During a downturn, demand for many of the goodies the EM countries produce will fall, and their export trade, which largely drives their economies, will falter.

A second reason is an extension of this phenomenon. Hedge Funds have been particularly large investors in the EM economies over the last decade. And, their investments have covered the complete range of securities: currency holdings, equities investments and their sovereign debt. But, now that the party is over, the Hedge funds are having to pony up on margin. This leads them to dump much, if not all, they bought. This is exacerbating the downturn, just when it is hurts the most. Isn’t that always how it goes?

During this huge sell-off, two currencies have become safe haven plays: the U.S. dollar and the Japanese yen. The number one and two economies in the world, regardless of how bad it looks, are still the safest places to put one’s confidence—or at least that is what the financial markets around the world are telling us.

This concentration of trends does, however, bring with it a potential upside.

• Given the serious decline in currency prices in the emerging markets, and
• Given that most all of them have financed much of their expansion of export production capacity with debt, and
•   Given that much of that debt is owed to the U.S., Japan and western Europe,
• Therefore, the banks and Treasuries of all the lending countries are getting antsy about being repaid.

Debt repayment by the EM countries is partially impaired by their falling economies. That is to be expected, because economic downturns are always expected after a period of rapid expansion. But, the problem is made much worse by the fact that their currencies are falling at the same time. Much of the debt they owe is denominated in dollars, so they now have a double whammy to face. Their revenues are falling because of their shrinking production, and their currencies are depreciating at the same time that the U.S. dollar and yen are increasing. Now, they have twice to three times as much problem in repaying their debt.

Lenders are quite upset. But, the lenders (large banks) have the ears of their respective governments, and no one in any government want more bad news to capture the headlines of the financial pages. They are working as hard as they can to contain the carnage that has already been unleashed. If they add defaults of some of the major EM countries to the list, it would set off a new round of tumbling confidence and stock prices.

Therefore, there is a move afoot to help the EM countries by a coordinated effort of the developed nations to enter the foreign exchange markets and buy EM currencies—helping prop them up, at least until things settle down a bit. If this rescue effort comes about, then look for EM currencies to have a good bump. ETNs such as JEM would benefit, as would individual currencies such as Brazil, Mexico, South Africa, Russia, etc..

This is far from a done deal, and any monies put into this type of speculation would be an usual risk. The deal may not come off, and their currencies could continue their decline. If there is intervention, then I would take a short term view of the improvements in currency prices, and have a strong idea of when to get out. For those with a strong risk appetite, this may be a good place to look.

I'm still bullish on the Dollar (UUP) and the Yen (FXY), and I consider these currency plays to be much less risky than betting on an intervention in the EM currencies.