US Macro shocks and style factors - Important in explaining EM currency moves

 

Emerging market currencies are very much related to the behavior of the US economy. This link is well-known, but the timing of market reactions is often not well-connected. The authors of the recent paper, "Emerging Markets Currency Factors and US High-frequency Macroeconomic Shocks" solve this problem by using higher frequency market data to proxy for growth and money shocks in the US. Their study finds that 40% of the time series variation in an EM currency basket is related to changes in macro shocks or risk premium in the US which is more than double the impact seen with developed markets. 

The paper measures these macro relationships through decomposing the behavior of US stock and bond markets. The financial markets when looked at in concert can decompose drivers of macro shocks into two categories fundamental unanticipated shocks to growth and money and the risk premium of growth and money. 

Instead of using fundamental data which is often delayed, subject to revision, and not produced with any frequency, the authors look at relationships with stock and bond moves. For example, if there is a positive shock to both stock and bonds, markets are signaling a growth shock especially if the bond reaction is in the front-end of the yield curve. If the markets are moving in opposite directions, the markets are signaling a positive money shock which will form expectations of a future tightening. 

The general trends of stocks and bonds moving together or in opposite directions also provide signals on the market risk premium for growth and money, respectively called a common or hedge risk premium. In this case, it is critical to look at the relative move of the back end of the yield curve.

The authors also construct style factor portfolios for emerging market currencies (carry, momentum, macro momentum, value, and high dollar beta) and find that all have exposure to high frequency US macro shocks, but when combined in a portfolio, the macro exposure can eliminated. The authors also find that carry and macro momentum style factor portfolios create positive alpha. 

The conclusion is that emerging markets are US macro sensitive and holding a single style factor will not eliminate the risk from US shocks. This paper provides a simple way of tracking shocks without delay and can serve as an important tool for EM currency trading.