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Where the Currency Bargains Are Now

Emerging market currencies have been laggards, but this strategist thinks that could change.

The currency markets have seen a jumble of news lately, what with easing moves by the Fed and the Bank of Japan - not to mention the debate at the Bank of England over more quantitative easing. But through the thicket of events, the status of the big four currencies is becoming clear.

The dollar, euro, British pound, and the yen, known as the G4 currencies, "will remain global liquidity providers for the indefinite future," says Steven Englander, global head of G10 FX strategy at Citigroup . In other words, these will be the currencies to sell against other higher-performing ones, thanks to weak or nonexistent economic growth and rock bottom interest rates.

What does Englander want to buy instead? He says emerging market currencies are looking cheap.

Englander has compared the performance of the "G10 smalls" - the G10 currencies other than the big four - to a basket of emerging market currencies. He found, he told clients, that in terms of performance relative to the G4 currencies, "the G10 Smalls have shot out the lights," but the emerging market currencies "are at best treading water poorly," possibly because G10 currencies like the Australian dollar are seen as safer - and certainly more liquid - than many emerging-market currencies.

Englander notes that the difference in performance has been especially pronounced recently, and it is giving him pause.

"Our question is whether this divergence is sustainable," he says. "Like the EM Smalls, the G10 Smalls are highly risk-correlated. There is also a strong commodity component in both, and given the stagnant growth in the G4, the marginal demand for commodities is more likely EM-based than G10-based. Our conjecture would be that the EM upside is significantly higher than the G10 Smalls on any indication that either the G4 liquidity flood is translating into either activity or a search for yield outside of G10."

True, central banks in China and many other emerging market countries have been reluctant to inject more stimulus, Englander says. However, he adds, "it is clear that sentiment is heavily pessimistic EM, while heavily optimistic G10 Smalls. The medium term trade may be the unwinding of this gap."

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