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.