EM FX Weekly: TRYing times

We are writing this in the wake of the huge devaluation of the Turkish lira and an speech from Turkish president Erdogan indicating he will maintain his defiant stance and refuse to take the traditional measures of hiking rates or appealing to the International Monetary Fund for a bailout. The situation is very fluid and next week looks like a critical timeframe for the situation to move towards a resolution of one kind or another.

Helmets on

We leave this week with markets in a fragile state linked to the accelerating risk of a Turkish default, both by its banks and possibly even the sovereign eventually after Erdogan’s defiant speech. We’ll provide the normal full update next week. Until then we focus on two things – foremost, of course, the direction of the Turkish lira and whether any further weakness continues to feed additional contagion risk across EM and even into DM currencies.

The euro, for example, was weak on the risk to EU banks from exposure to Turkish banks. The other factor on the loose is the stronger US dollar, in part due to the Turkey-inspired sell-off, but also in the wake of the EURUSD sell-off through 1.1500. Further USD strength is generally associated with pressure on emerging markets, but extra attention on the USDCNY rate is also required as the Chinese currency’s level versus the dollar garners intense scrutiny and likely anxiety if the USDCNY is allowed to rise above 7.00 after China’s recent efforts to short-circuit further weakness.

The danger for Turkey is that at a certain level for TRY, the Turkish banks run out of excess capital to service debt denominated in foreign currency, debt estimated at 30-40% of Turkey’s GDP even before the most recent TRY devaluation. At a sovereign level, the default probability has moved beyond 25% according to CDS prices on Turkey’s sovereign debt – see in chart below.

President Trump added insult to injury on Friday with a tweet calling out bad relations with Turkey and a doubling of tariffs on steel and aluminum for Turkey relative to other exporters.

Chart: USDTRY and Turkey CDS price

There is no real technical analysis on a currency that is in freefall, but once the speed of the move turns parabolic as it has this week, the timeframe is likely rather short until some sort of at least near-term climax is reached. Next week looks like the time frame for the situation to reach some sort of temporary “resolution”.