EM FX Weekly: EMs' fate in Powell's hands

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.