Head of FX Strategy
Market conditions have calmed a bit after Turkey’s strongarm tactics aimed at limiting speculation. But nerves remain frazzled and Turkey is by no means out of the woods, and neither will emerging markets be out of the woods until the Powell Fed charts a change of course away from its tightening regime. Cue next Friday’s speech from the Fed chair that the market hopes will signal that the Fed put remains alive and well, even if we’re not yet at the exact strike price. If Powell completely shrugs off recent developments, a fresh EM tantrum could lie dead ahead.
Spotlight EM FX picks this week
TRY: the weakness in the Turkish lira peaked shortly after our report last Friday and the contagion effectively peaked on Monday of this week as Turkey moved to do what it could on the damage control front. The two key initiatives were the moves to limit speculation in the FX market by reducing liquidity in the swaps market and a commitment from Qatar to invest $15 billion in Turkey as the former owes Turkey a debt of gratitude for its alliance with the tiny state during its showdown with Saudi Arabia and other Gulf powers stretching back to June of last year. The market conditions for trading lira are far more difficult now as a further devaluation has been priced into the forward curve and implied forward yields are very high – i.e. the cost of carry for holding short lira positions is likewise very high. At pixel time, the Turkish lira would need to weaken at a faster pace than 30% per year for speculative shorts to realise a profit.
CNY: China has so far kept a floor in place for its currency – keeping the 7.00 level in USDCNY at bay. Its efforts have been somewhat aided by the relief rally in EM currencies this week as at least a (short term?) climax came in and went over the last week. The market also took heart this week as China announced it would send an official to the US for for a “low-level” resumption of trade talks and the Trump administration suggested it was willing to talk if the US side could get a better deal. The New York Times ran a story suggesting that the US would push for CNY strength as a component of its stance on trade. We’re far from convinced that China will sign on to anything that looks like a loss of face for its side and that Trump likewise won’t cave in any way ahead of the mid-term elections in early November. Until then, will China keep the floor in place... until at least the other side of the upcoming low-level talks?
BRL: Brazil is a mess and we are struggling to see positive outcomes for the country, particularly given the stressful backdrop for EM. The first round of the presidential election will be on October 7, with extremely uncertain outcomes. Recall that the Mexican peso bottomed out a couple of weeks before the election before rallying very strongly. But the parallels with Brazil are few. Brazil’s most popular presidential candidate, Lula, is in jail, Brazil’s economy is barely growing and the government urgently needs to reform the national pension scheme to shore up the trajectory of its budget – a budget that faces further challenges after the recent crippling strike forced officials to reintroduce fuel subsidies. An ongoing sense of disorder plagues sentiment and there is considerable popular support for a military coup. The news emerged over the last week that the country sadly saw a record murder rate in 2017 and a recent poll from Datafolha suggested that 56% of college-educated Brazilians would emigrate if they could. To make things worse, Brazil’s export mix is highly leveraged to China, which is dealing with growth and financial concerns of its own.
CLP and PEN: the ugly sell-off in copper prices and the risk of labor unrest at Chiles huge Escondida mine saw the CLP sharply weaker over the last week and PEN was also finally shaken from its recent semi-peg by the EM developments and the specific copper story. Peru’s largest export is copper, followed by gold, which has also been on an ugly slide of late. We have highlighted the Chilean peso as a candidate for further weakness and have also mentioned its very large external debt exposures in foreign currency terms – a factor risking increased scrutiny from EM investors after the Turkish situation has highlighted the risk of debt denominated in foreign currency. Chile has a small current account deficit of 1-2% of GDP, but further erosion due to weak copper prices is a risk down the line. A re-rating of Chilean debt is another risk.
Chart: USD-denominated bonds spreads for selected EMs
The chart below shows the yield spread between US dollar-denominated EM sovereign bonds and their US Treasury counterparts with a similar maturity. No surprise that the spread on Turkish sovereigns blew wider as the Turkish lira crisis unfolded. But note developments elsewhere: for example Russian, South African, and Chilean yield spreads are also near the widest for the cycle. In Brazil, meanwhile, the country has managed to avoid new spread extremes – possibly as Brazil has a very small sub-1% of GDP current account deficit and its external debt load is more modest than the worst cases. Similar is Indonesia, which though it has a 3% of GDP current account deficit, has a more manageable external debt load below 25% of GDP (according to the IIF) and where the central bank has responded aggressively with rate hikes. Of course, all Asian currencies will inevitably suffer volatility if China’s commitment to the seeming CNY floor is abandoned.
Chart: Global Risk Index – a brief stay in positive territory indeed
Risk conditions worsened sharply recently and it would take some considerable lifting of sentiment and our family of risk measures to pull our indicator sustainably back into positive territory. The most notable development this time around in the negative tilt of our indicator is that all of the components have been swimming in the same direction, led of course by the ugly new deterioration in EM credit spreads. We’ll look for further signs of contagion, but for now we would just note that the absolute levels for indicators like corporate credit and market volatility are still rather muted relative to historic bouts of volatility when real contagion risk across markets is afoot.
We remain as defensive as ever in the forward outlook for EM currencies, though values in some currencies are beginning to look attractive. A 70%-plus decline in Turkish equities, for example, certainly looks interesting for long-term holders, even if it appears far too premature to speculate on any sustained recovery in the lira. The strong US dollar is the chief risk indicator of the moment with USD liquidity squeeze is at the heart of EMs' structural vulnerabilities as the Fed tightens policy on a funding currency that has been far too popular over the last decade.
As ever, we keep our eye on the CNY for the risk of the floor giving way, and this is something that has a kind of a “binary” feel about it – i.e. would China allow the USDCNY rate to merely crawl higher in the face of further USD strength, or just let it rip? China has vowed it won’t pursue a CNY devaluation as a policy, but it could easily argue that USDCNY above 7.00 is merely driven from market forces if there is a strong USD backdrop.
But the most readily identifiable event risk that could either introduce a bit of a relief rally in EM or engineer a significant new meltdown on the scale of the 2013 taper tantrum is the speech by Fed chair Jay Powell at next Friday’s Fsyposium in Jackson Hole, Wyoming. This yearly event has been the launching pad for major moves in global markets, particularly the 2010 Jackson Hole speech from Ben Bernanke, which signaled the coming of the Fed’s QE2 policy. If Powell shrugs off Fed responsibility for USD liquidity conditions globally after this recent episode, it may remind the market of what it fears most: that the so-called 'Fed put' has a much higher lower strike price than was the case under Greenspan/Bernanke/Yellen and that the put will only be exercised with domestic US considerations in mind.
We would suggest that the risk of this stance is rather high and remind our readers that Powell speaks in a very frank manner that the market may not have fully adjusted to after the 30-plus (!) years of dovish wishy-washiness under his predecessors.
EM currency performance: Recent and longer term, carry-adjusted
Chart: weekly spot and one-month carry-adjusted EM FX returns versus USD: The Turkish lira volatility on obvious display here as the currency posts the strongest one-week performance together with the worst one-month performance. Elsewhere, the picture is mostly negative for the one-month timeframe as all of EM has been spooked by a fresh bout of risk-off, USD strength, and the sharp CNY weakening. The “next domino” if we are to see a wider spread contagion, is widely expected to be South Africa due to its external indebtedness and current account deficit, and no coincidence that the ZAR has posted the weakest one-week and one-month performance after TRY.
Over the next week, we will scrutinise any signals from the Fed’s Jackson Hole symposium (especially Powell’s speech) and whether the CNY floor is kept in place as these are more important now for EM than Turkey for the broader EM risks.