Conditions for EM currencies have worsened further as global bond yields have rebounded after the Italian election-inspired disruption and as EM credit spreads have shown further signs of strain. The odd indicator out remains suppressed market volatility, as low volatility and strong risk appetite in developed markets rarely coincides with EM currency distress. This week’s FOMC meeting could throw a lifeline to emerging markets if the Fed slows its quantitative tightening schedule and/or loosens its commitment to the current pace of rate hikes. But this is far from a sure thing, as the Fed may be looking for more flexibility rather than trying to make the explicit dovish shift that would provide some more profound near-term relief for EMs.
EM developments over the last week
A few specific EM currency developments for the EN currencies with the widest performance swings this week:.
TRY: the Turkish lira managed a resilient performance last week after the Turkish central bank hiked the repo rate 125 basis points in a move that few anticipated. The extreme TRY carry helps to offset the strain on Turkey’s credit spread, which has worsened back toward the worst levels for the cycle even as the lira exchange rate has at least attempted a recovery. The currency weakness should begin to right the current account situation in the months ahead as well. The next critical steps for Turkey lie on the other side of the June 24 presidential election and how President Erdogan responds to the flogging the country’s exchange rate has been administered by global markets. Has he been cowed or could he reach for desperate measures? The potential is there for a full blown crisis and even default if conditions for EM worsen further and Turkey’s leadership makes the “wrong” decisions.
BRL: The Brazilian real saw a roller coaster ride over the last couple of weeks, first lurching into an ugly slide even after a paralysing strike concluded as a rising popular chorus supports military intervention and the right-wing populist Bolsonaro gained political momentum from the episode. Last Friday, however, the Brazilian central bank made a more pointed promise to deliver enough intervention to stem the flow out of the currency, and the BRL rallied to recover all of the losses over the prior week. The actual spread on Brazilian USD-denominated debt versus a US treasury counterpart has not improved, however, as we point out below, so the sustainability of the real’s comeback is still an open question as the country faces a long wait until October elections and the new angle of (also an echo of Brazil’s past) right-wing populism and the military in the mix.
Chart: We highlight a quartet of the EM currencies below for which credit spreads on USD denominated debt has worsened again recently to, or close to, cycle wides. Without improvement in the appetite for EM assets, the currencies will remain under pressure and the recent volatility may have also seen hedging demand for existing portfolio exposures picking up. All four of the countries charted below have sufficiently large external debt loads that point to the risk of the situation getting worse if authorities can’t improve foreign investor confidence. Note the remarkable situation in South Africa as well, where the specific USD bond yield spread is almost back to where it was when the currency was under the most pressure during the final portion of former President Zuma’s rule late last year.