Markets showing dreaded risk-on, risk-off tendencies

John Hardy

Head of FX Strategy

It appears that Turkey’s authorities are looking at the 7.00 are in USDTRY as an intervention level, or at least that is the tactical line in the sand that developed over yesterday’s trading session. But it is also the level around which some have calculated that Turkish banks effectively run dry of excess capital to service foreign currency denominated obligations. 

The most recent Turkish debt auctions and trading in the second hand market are pricing Turkish debt at around 25% at the short end of the curve and 21% out to 10 years. This makes a mockery of the policy rate of 17.75%. 

What Turkish president Erdogan’s plans are from here is unclear, but the risk is growing of a geopolitical shift and abnegation of foreign debts is growing and a chaotic default and/or capital controls will test the robustness of the global financial system. 

Today sees a busy Erdogan schedule and for interesting potential geopolitical developments, do note that Russian foreign minister Lavrov is in Turkey and will hold a joint press conference with the Turkish foreign minister around lunch time (possibly 12:30 local time) today. 

For the most fire-and-brimstone view of where this is all going, have a look at Russell Napier’s piece posted on ZeroHedge. Others are less concerned. We’ll take a wait-and-see approach, but the Rubicon has been crossed for Turkey’s economy and the chief question is not the magnitude of the Turkish situation itself, but the degree to which the contagion from Turkey challenges the narrative and triggers a reassessment of counterparty and financial risk across other emerging markets. 

As well, global confidence risks getting shaken to its core if the Turkish situation triggers concern that China will be forced to devalue its currency versus the USD.

Elsewhere, Italy’s yields are ratcheting higher and yesterday’s closing yield for the two-year at 1.33% is the highest in about two months. Italy’s new leadership is casting about in an Erdogan-esque manner for blaming evil speculators for Italy’s high funding costs. At the same time, they are insisting on the need for a populist-driven fiscal expansion while making noise about reducing Italy’s debt load. Leaving the euro and defaulting is the only way Italy will achieve a reduction in its real debt load (or launching a parallel currency that devalues via the exchange rate).

Chart: EURUSD (weekly)

A look at potential targets for the move lower here shows that just below 1.1200 is the 61.8% retracement of the entire rally from the early 2017 low to the top earlier this year. But if the crisis intensifies to fever pitch, lower levels still are a risk, and some may be tempted to see a head and shoulder formation with a technical target closer to 1.0500. That’s a bit too much for our taste for now and we’ll simply take the tactical view that the action looks bearish as long as we trade below the 1.1500 area here.

Enlarge
Source: Saxo Bank

The G-10 rundown

USD – the USD squeeze higher is easing a bit this morning, but have we really seen the climax for now? We have our doubts, and further risk-off behavior could drive another spike or two of USD gains on the theme of waning USD liquidity. The signals from next weekend’s (August 24 and 25) Jackson Hole conference in the US could prove critical.

EUR – the euro oddly stable despite Italian yield spiking higher, but the minute-to-minute focus seems to be on whether TRY is up or down. Keeping a cautious stance on the single currency until morale improves and as long as we remain below 1.1500 in EURUSD .

JPY – USDJPY bouncing hard enough to make life difficult for the bears here – but more upside needed to indicate that the USD can outperform even the JPY in a risk-off/global contagion scenario.

GBP – UK data up today, but EURGBP is more about EU existential and Turkey risks on the euro side and Brexit developments on the UK side, so not sure we get a sustained reaction to today’s data releases.

CHF – EURCHF bouncing after the steep plunge as we see the lira bid in early trading this morning. The pair is a pure risk proxy and we doubt the lows have been posted just yet.

AUD – AUD remains weak despite the attempt to manufacturing a bounce in risk appetite this morning as the weak Chinese data overnight weighs on the currency.

CAD – CAD offering very low beta to the risk-on/risk-off markets and may be looking a bit more at the oil price for direction and whether the narrative can switch back to relative central bank policy moves.

NZD – kiwi somehow mounting a comeback against the Aussie – perhaps on the latest developments in China and sense that the Australian economy is more leveraged to China, and if 1.1000 is fully taken back in the AUDNZD pair, it could be curtains for the bulls.

SEK – SEK trying to claw back some gains after trading to the high of the range. Isn’t it unfair at some point to continue to see SEK lower if the EU existential risks worsen?

NOK – Norges bank incoming on Thursday. Given the global backdrop of the moment and falling Norges bank rate expectations, we’re not expecting any bombast in the new guidance.

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