We expect this uphill battle to extend into 2015 as the main forces that drove EMFX in 2014 are still in place. However, we believe that these headwinds are poised to ease as the year unfolds, since we believe that: 1) the upside for the USD into 2015 is about one-third of what we saw in 4Q14 (and possibly concentrated in 1Q15); 2) oil prices have already approached the bottom of our expected range; 3) the political calendar will be considerably lighter; 4) policy uncertainty has reduced; and 5) EM growth will likely pick up some steam over the next year. On aggregate, we forecast EMFX spot slightly stronger in 2015. This, plus the usual contribution from carry, as the chart below shows, should eventually benefit portfolio flows.

Central banks: Not to the rescue. As one important byproduct of the recent fall in commodities, investors will still face mostly dovish central banks. In addition to reduced inflationary pressures (mostly outside LatAm), central banks see EM currencies as their main line of defense against external and domestic shocks. This – in addition to policy divergence and differences in exposure to oil – have underpinned our preference for INR, IDR, TRY vs. BRL, RUB – and to a lesser extent ZAR (where downgrade risks will linger) – among the high-yielders.

Although we believe that the dovishness of central banks is to a large extent priced among the lowyielders in EMEA, it will likely continue to weigh on Asia FX. With the JPY, food and energy prices down, we expect the need to preserve value to drive policy in SGD, KRW, and THB. We also see BNM shifting its line of MYR defense to 3.50, while PHP remains vulnerable to perceptions that monetary policy is falling “behind the curve”. In LatAm, the room for easing monetary policy is a lot less given high inflation and the region’s FX exposure to commodities, but we believe that further easing will keep CLP undervalued in the first part of 2015, at least.

Eoin Treacy's view

Here is a link to the full report.

The Dollar’s rally this year not only against the Yen but a host of emerging and developed market currencies has been both outsized and counter to the trend that has prevailed for the better part of a decade. Commodity prices, electoral cycles and central bank actions have all been major factors but the relative strength of the US economy is perhaps the most notable factor of all.

No currency can be spoken of in isolation but the relative strength of the US economy at a time when much of the rest of the world is turning to easing monetary policy represents a headwind for Dollar carry trades. The Dollar was the carry trade currency of choice for much of the last decade as interest rates fell, emerging market currencies strengthened and liquidity was abundant. With the end of the Fed’s QE program, availability of Dollars is now in question, the Dollar is strengthening from historically low levels and interest rate differentials may tighten. The volatility in currency markets alone is a reason to eschew the Dollar as a funding currency for carry trades.

I suspect that this factor is being underestimated by analysts and represents a reversal of a decade long trend. The commonality of currency strength against the Dollar has broken down and is unlikely to return any time soon. This suggests that each currency will need to be assessed on its individual merits and there will continue to be clear winners and losers.