Follow EM or not? That is the big question that BofAML asks as once again Emerging Market stocks are decoupling (lower) from an exuberant US equity market.
After a big rally in risk assets today the S&P 500 is up and credit tighter (CDX IG)/ higher (CDX HY) relative to the levels on May 16th – the day before speeches by Fed officials and later the FOMC minutes re-priced the probably of a June rate hike materially higher. After today’s strong new home sales report and a decline in Brexit risks (GBP up 1.0%), the implied probability of a June rate hike increased further to 34%, the dollar rallied (DXY dollar index is up 0.4%), 5s30s Treasury curve flattened by 1.5bps and financials outperformed (up 1.55% vs. 1.37% increase for the S&P 500).
However, we are seeing the same decoupling between US and EM stocks that that turned out a leading indicator for the decline in US risk assets in August last year and again in December/January this year…
As we noted last night, we suspect this is China-driven volatility rippling through from EM equities and FX inevitably spreading to US equity markets through various carry trades.
So the question is – will the Yuan turmoil ripple through markets enough to spook The Fed once more and dissolve what little credibility they have left or will Janet and her henchmen stand up to the foreign forces, hike rates to spit their own face, and deal with the aftermath through some more Citadel-driven VIXtermination? With VIX futures near record shorts and S&P futures at their longest in almost 2 years – there's not much easy leveraged money to squeeze there – like there was in August.
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