The show must go on

My decision to not go on vacation is finally paying off. Who would have guessed that the last week of July and the first week of August would be two of the most interesting market weeks seen in a long while? After years of close to zero volatility, it’s finally is time to take the guns out and “get to the chopper”.

If investors were shocked to see the 10-year US Treasury yield rise above 3% last week, this week’s reality check has been the volatility in Turkey. This reminded investors that volatility in the US, Europe, and Japan remains muted by central banks’ massive balance sheets. Outside of these countries, however, risk-off moves are met by ugly market reactions. 

The 10-year Turkish government bond yield has spiked to 20%, while the Turkish lira has fallen to 0.1875 versus USD – down 28% down from the beginning of the year. 

Could this be a buying opportunity?

Hold off from Turkey for a little longer

The way that things are developing in Turkey is not healthy, and things are about to get even riskier as Erdogan is playing a dangerous game with president Trump, who has already demonstrated that he will not demur from imposing tariffs to secure his agenda. This could lead to serious further downside for both the Turkish lira and Turkish sovereigns.

Apart of the risk of tariffs, and Saxo Bank Head of FX Strategy John Hardy has mentioned, the only things that can save Turkey at the moment are:

1. Central bank independence: this is the biggest gamble, as even though Erdogan may have appeared to step back from outright meddling, his power and political views still affect those of the Turkish Central Bank. So long as Erdogan remains in power, we can expect the country’s central bank to maintain only a fragile independence relative to the president’s will.

2. Tighter fiscal policy: the Turkish economy is crying out for a rate hike. If this continues to be put off, we can expect inflation to continue rising while sovereigns and the TRY suffer.

3. A potential International Monetary Fund bailout: This could be a game changer for bond investors as it would give international investors comfort regarding Ankara’s ability to repay its debt, especially in foreign currencies. 

If none of these factors come to pass, we can rest assured that more volatility will hit the Turkish market. Although the five-year CDS level is presently at a 10-year high of 347, it could rise to its financial crisis level of 400 if volatility is not contained.

Turkish sovereigns aside, the biggest risk lies in Turkish banks. Although this sector previously appeared well-capitalised, the depressed lira and the consequent rise in the cost of funding means that Turkish banks are having a hard time refinancing existing debt. This might provoke a liquidity squeeze that could drive real money to rethink its exposure to both Turkish assets and emerging markets in general.

Risks to watch out for include the upcoming meeting between US and Turkish officials in Washington as well as Erdogan’s rhetoric on monetary policy.

Opportunities in India

The simple “buy EM” strategy of the past has turned out poorly. We are now entering a new trading phase that will affect weaker credits, and EM in particular. A selloff in this space is now inevitable and the main reasons are a strong dollar, the continued rise of funding cost,s and of course, trade war headlines.

We still believe, however, that there are still good opportunities in the EM space. These economies are still driven by a positive trend of EM consumer spending, especially in China and India. Although we are still positive on China despite the US trade war weighing down Chinese stocks and bonds, we believe that best opportunities are to be found in India.  

The Indian bond market has been suffering for a few years now and the yield of the 10-year Indian government bond rose by approximately 180 bps to 7.8% from November 2016 until now. These levels, however, are already pricing in the negative external factors discussed above. 

Another key consideration is that even though the Reserve Bank of India as already hiked interest rates twice since June, it signaled last week that it is not looking to tighten policy any further. One more factor that might support Indian credit is the central bank’s plan to make open market purchases to adjust the rupee’s liquidity conditions.

In this case, it seems that the RBI is ahead of the curve.

While it is not possible to trade rupee-denominated Indian government bonds on the Saxo platform, it is still possible to gain exposure to the Indian yield curve through USD-denominated Indian supranationals and corporates.