research.hsbcDisclosures we now see USD-RMB rising further.Tariffonomics likely bond sales by foreign investors causing FX weakness; increased economic imbalances both in terms of domestic asset bubbles, and externally from a trade perspective; and concerns around monetary policy independence. This negative relationship has held for some currencies in the recent past. The combined fiscal and monetary expansion in Hungary in 2017-2018 helped to fuel a near 10% move higher in EUR-HUF. The TRYs struggles in 2018 might have been catalysed by geopolitical developments, but also came against a backdrop of loose policy on both fronts, at a time of high inflation. Italy has also faced challenges when talking of fiscal loosening although this might reflect market concerns about the potential currency mismatch of issuing debt in EUR. In any case, the FX impact of possible fiscal indiscretion in Italy has been fleeting at best. Indeed we are seeing signs that the traditional relationship appears to be breaking down, meaning currencies have been able to withstand this cocktail of loose policies. The most obvious example is South Africa, in our view. South Africas fiscal position has been loosening markedly for the last three years and expectations are that this deterioration is only going to continue (Chart 7). This may not be a fiscal loosening in the same sense as seen in the US or Poland. Most of the widening of South Africas deficit is a function of poor growth limiting revenue gains and an increasing requirement to provide support to state-owned enterprises (see New Eskom bailout deepens fiscal risks, 25 July 2019). On top of this fiscal loosening, monetary policy has also recently turned more dovish with the SARB delivering a 25bp cut in July and signals of further easing to come. 7. Ongoing and significant worsening of South Africas fiscal position 8. But SAGBs have staged a strong rally since late last year -7-6-5-4-3-2-102010 2012 2014 2016 2018 202 0 fGe n er al g o vt b u d g et b al an ce, % GD P H SB C F orec as t6789101167891011J a n -1 4 J an- 15 J a n -1 6 J a n -1 7 J an-18 J a n -1 92030 bond y iel d 12* 15m F R A% %Source: SARB, HSBC Source: Bloomberg, HSBC However, the ZAR and local South African assets performed well in the first seven months of the year. Bond yields have fallen quite sharply since late last year (Chart 8) despite the massive intensification of fiscal pressures that are not just cyclical in nature, but structural. In the past the bond and FX market “vigilantes” would step up to push yields higher and weaken the currency in order to bring such a fiscal position into line. So why is this not the case? 9 Currencies Global August 2019 We see three linked reasons why FX has been immune to these supposed pressures: a. Low inflation: One of the threats of the loose fiscal-monetary combination was always inflation, which erodes away the value of a currency and its bonds. But global disinflationary pressures appear so entrenched in both G10 and EM (Chart 9) that market participants may feel confident inflation will never return, and therefore that bond and FX risks are much diminished. Where there has been idiosyncratic inflation in EM in Turkey and Argentina for example there has still been commensurate weakness in FX. But if there is no inflation, there is much less risk for the currency. b. Low core bond yields: This global lack of inflationary pressure is allowing G10 central banks to turn even more dovish. The Feds pivot from hiking to neutral to cutting has been ongoing since September 2018, while the ECBs most recent communication suggests rate cuts deeper into negative territory and more QE are coming. This developed market easing acts as an anchor for global yields, increasing demand for higher yielding assets (Chart 10). Right now it seems this global factor trumps local factors in emerging market bonds and FX. c. Central bank backstops: this dovish behaviour may be prompting investors to believe that central banks in any economy could act as a buyer of last resort for government debt should the need arise. QE has been used effectively to drag yields lower in the US, Eurozone, Japan, the UK and Sweden without generating inflation. This is one reason we argued that large levels of government debt may not be a concern for G10 FX in Dollar: The best of a bad bunch (8 January 2019). Investors might even be starting to believe EM currencies are also able to capitalise on this potential policy protection if there is seemingly no threat of inflation. 9. Inflation pressures remain subdued globally with EM converging on DM 10. Core bond yields are pushing back towards record lows -20246810-20246810J an-04 S e p -0 6 M ay -09 J an-12 S e p -1 4 M ay -17EM C PI Y o Y* D M C PI Yo Y* *0. 00. 51. 01. 52. 02. 53. 03. 54. 00 .00 .51 .01 .52 .02 .53 .03 .54 .0J an -0 5 J an-08 J an -1 1 J an-14 J an -1 7A v er ag e of G3 10 y go v t bo nd y ie ld s* PPP weighted average of Brazil, China, India, Indonesia, Mexico, Poland, Russia, S. Africa and Turkey; * PPP weighted average of Germany, Japan, UK and the US Source: Refinitiv Datastream, Bloomberg, HSBC * G3 = US, Japan and Germany Source: Bloomberg, HSBC If these three points hold, then it may well be that investors give some leeway to governments and central banks that follow accommodative fiscal and monetary policies. We struggle to believe this policy combination can be a good thing structurally. Ultimately such a policy stance should fuel economic imbalances that will have a negative FX impact. We have differentiated in our preferences in EM FX for some time, believing that not all carry can be equal for emerging markets and that investors should be selective between those currencies with more positive domestic stories and those facing idiosyncratic challenges (see EM FX Roadmap: Thorns and roses, 24 July 2019). But while these external conditions remain in place it can sometimes be hard to identify a catalyst that would cause these currencies to weaken suddenly, even if they have growing structural concerns.