In the current low vol regime, one might be concerned that EM asset outperformance may be plateauing, where it is important to re-assess just how much specific country plays can continue to perform. We take a look at Indonesia below. Indonesia’s fixed income appears quite rich to be confident of any outsized meaningful gains from here. Yield compression is already very extended with the 10y INDOGB yield rallying 100 bps YTD, and to levels which suggest it is stretched, when compared to the outright level of intermediate US rates. A closer zoomed in chart shows that the Dec 2014 low of 7% is currently being retested on the INDOGB 10y yield after a break lower, and although this seems tempting to buy for another rally for lower yields, the risk:reward is arguably not compelling as before. The beta of returns for Indonesian bonds are relatively high to US rates, high not only versus its Asian peers but other high yielders as well, Russia and South Africa. This is great for buying on dips of short-term US-rates / global driven shocks as Indonesia will be squeezed further, but this isn’t too great for when you’re at the later stages of a rally.
The term structure of FX vol can be used as a proxy of how stretched an EM ccy is, where inversions in the term structure can be thought of as potential filters for dip-buying opportunities. We are now at average levels in the term structure suggesting that a lot of the value has compressed so to speak. On the domestic line, Bank of Indonesia is likely to keep policy steady at 4.25%, which may cap further gains for FI, even with the current low inflation backdrop. Property prices and rent prices, and rice prices account for 20% of recent years’ disinflation. Food inflation is at 3.5% (closer to 5% average in 5yrs), near historical lows and rent prices look to have troughed. Local commercial banks have noted that there’s little need for BI to cut further with liquidity conditions improving, and lending growth needs time to renormalize as banks clear NPLs from the Oil fall in ‘14. In addition to this, BI would be likely to be aware of cutting too much with tax reform agenda in the US progressing, to prevent aggressive capital outflows. This can be a case for mean-reversion in the near-term, where steady fundamentals, year-end trading, and a pause in cuts could see USDIDR fading the 13500 resistance,( it seems worth to fade the level smalls-ish) to target 13300 - 13000 (ambitious), for a year-end tactical trade, which also seems worth to buy the recent dip in broad EM.
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Swiss inflation is still hovering close to zero, and even though EURCHF FX is now at 1.16, bringing YTD CHF depreciation to around 7.5%, domestic macro is highly unlikely to warrant a regime change in SNB monetary policy, added with the fact that the SNB is still applying sensitive language with the Franc. The SNB only expects inflation to recover to above 1.1% by 2019, and is conditional with CHF LIBOR remaining at -0.75% (current) throughout the timeframe, and only to reach 2.0% by 2020. Broad growth is likely to trough around current levels slightly above 0% from where we are now with industrial production data rebounding, and leading indicators such as expected capacity utilization back at 2014 highs of 20% and money growth continuing to trend upwards. We did have a few false starts from 2015 in the Swiss economy so I would not be too quick to assume “this is the big regime change and Switzerland makes it to 2% growth”.
Survey expectations for inflation for the next 3-5 years remain at 1.05% (this is not yet close to the 1.65% figure we saw in 2013), and the current pickup of core CPI at 0.5%, is still minute to warrant any policy changes (even when adjusting that Switzerland experiences lower inflation to other developed economies). Inflation tends to underperform to year-end in Switzerland, which a slight, additional side-reason why I am not too overly excited with inflation back positive again year-to-date.
A good way to express a ‘cap’ in near-term growth expectations is via a CHF 6m6m / 1y1y flattener, which as a trade also looks quite good to balance a rates book that may-be net short. The curve is at 17 bp and around here to 20 bp seems like a good level to fade any near-dated risk premium. The trade rolls +8 bp over the course of 6m, which always helps.
The only downside to the structure is that it does retain some beta to the same curve points to the EUR but even so I think the 1y1y point is quite safe to not warrant too much back-leg steepening pressure in the EUR which may spillover to the CHF. Perhaps a cleaner way to trade it to remove the beta on the swaps curve to the EUR, would be via STIRs, looking at the z8/z9 spread where it’s currently at 25 bps, to play a flattener there to 20, or long the M8 contract outright around 100.60 to the 100.8 levels (around where CHF libor settles).
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