Conclusion: The global currency market is telling us to remain long of The Inflation, which, among many things, includes being short emerging market debt. Relative to consensus, we ascribe greater probability for accelerated EM rate hikes over the intermediate term.
Position: Short EM local currency debt via the etf ELD.
On Friday afternoon, we initiated a short position in WisdomTree’s Emerging Markets Local Debt Fund (ELD) within the Hedgeye Virtual Portfolio. While certainly not a new idea (we’ve been bearish on EM bonds since early November), we did see an attractive entry point on the short side, with the ELD trading at just over 1% below its TAIL line of resistance at $52.75.
As a recap, the core tenet of our bearish thesis on EM local currency bonds primarily stems from the intense commodity reflation we’ve seen since Jackson Hole. Such increases in commodity prices apply significant upward pressure on the reported inflation rates of developing nations, as food, energy, and other primary goods typically garner higher weightings in their CPI calculations (relative to developed nations).
As such, we’ve seen central banks from Asia, to Latin America, to Emerging Europe tighten monetary policy over the last six months or so; China, Indonesia, South Korea, Thailand, Brazil, Russia, and Poland are notable countries currently engaged in a rate-hiking cycle.
As crude oil prices continue to inch higher on weak US dollar policy and MENA instability, we anticipate the transposing effects of higher energy prices to continue percolating throughout their economies, as cost increases get increasingly passed through to consumers. That is likely to result in an accelerated pace of rate hikes, as traditionally dovish EM central banks like Mexico are forced to react to inflationary forces that are less transient in nature.
It is our official call that crude oil continues higher over the intermediate term, with potenital upside beyond $120 on WTI. We stick by our long-held view that the situation in MENA will not be short lived, contrary to many pundits who incorrectly predicted near-term resolution earlier in the year. In addition, we don’t see any meaningful-enough shifts in US monetary and fiscal policy capable of stabilizing the dollar above its TREND line of resistance.
The US Dollar Index is in a Bearish Formation from a quantitative perspective, which suggests that inflation is more than likely here to stay over the intermediate term. While that is subject to change with more price, volume, and volatility data, for now, the global currency market is telling us to remain long of The Inflation, which, among many things, includes being short emerging market debt. And given the XLE’s run-up YTD (+17.5% vs. only +6% for S&P 500), we suspect some investors might want to start looking for less consensus ways to play this trade.