Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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A wild session in Asia on TRY contagion
John J. Hardy
Chief Macro Strategist
The worsening of sentiment Friday spilled over into the early hours of trading today until Turkey’s finance minister promised to announce a plan to address the lira crisis. But the list of options is not attractive and President Erdogan has spoken out against the most effective option, which would be a radical increase of rates.
In a more normal situation, the country’s political leadership would have to admit defeat and appeal to the International Monetary Fund for help, but Erdogan will not reach for this option as he sees it as a loss of credibility.
Other EM currencies with large USD debts in their private sector were also in for a drubbing overnight, particularly the South African rand, which suffered a flash-crash like 10% devaluation overnight before bids came in and reversed.
The contagion from the TRY situation is spreading across all assets and around the world, as even a higher than expected (highest since the global financial crisis) core US CPI print at 2.4% couldn’t keep US treasuries from rallying steeply.
In G10 FX, as the situation worsens, the pattern seems to be that the USD and CHF remain approximately equally strong, while the JPY is stronger still and the euro is divergently weak despite its liquidity due to EU banks’ exposure to Turkish debt.
The single most important factor to watch in the currency space besides the TRY and whether this source of the contagion can be turned, is whether China allows the USDCNY rate, clearly under enormous pressure given what is unfolding, to move beyond 7.00. This could in turn provide additional fuel to the markets’ concerns.
Chart: AUDJPY
AUDJPY is the classic risk-off pair within G10 and this time is no exception as the pair looks at the big 80 area and therefore the lowest level since late 2016. As market volatility heats up, traders should recognize that it is very difficult to find diversification as correlations quickly head toward 1. So for the short term, AUDJPY will move in synch with EURCHF, EURUSD and NZDUSD in all likelihood until the market’s temperature drops again.
The G-10 rundown
USD – the US dollar playing second fiddle to the Japanese yen, but the greenback still a clear liquidity safe haven as risk contagion has spread. Note the higher than expected 2.4% core CPI level completely ignored and sees a steep rally in US treasuries/lower yields all along the curve.
EUR – the euro trading almost like a risky currency given concerns that EU banks. This angle may be somewhat overplayed by the market as Turkish loans don’t represent a systemic risk, though it is fair to say that the EU is politically poorly prepared for dealing with a mini-crisis and who gets what from the ECB – meanwhile, Italy’s spreads are widening again and this drives a different angle on euro weakness.
JPY – the yen is the classic safe haven when risk appetite declines go global as Japanese savings sloshing all over global capital markets head for safer harbours.
GBP – sterling actually outperforming the euro as the UK is seen as less exposed to Turkey. Technically, the EURGBP rally looks nearly reversed here, though in the shortest term, if Turkey can turn the sentiment in the near term, this pair may pull back higher and go back to being driven by the Brexit narrative.
CHF – the Swiss franc serving as a safe haven from EU existential risks. Expecting nearly complete correlation with EURJPY, for example, if the TRY risks fade and/or if Italy goes back to its status as a slow burn issue.
AUD – Aussie is lower on all of the risk contagion and AUDUSD managed new lows rather quickly late last week. The technical line in the sand in AUDUSD is 0.7300-50.
CAD – USDCAD pulling higher, but seems to have low beta with the risk contagion effect across markets. Rate spreads for US versus Canada are heading in the opposite direction of price action, but still, an ugly crude oil sell-off could yet drive a weaker CAD here.
NZD – not sure that the AUDNZD move back from recent highs reflects anything more than the market distracted by risk contagion and possibly AUDUSD selling. Still prefer that pair higher if trader’s can rediscover the dovish RBNZ plot.
SEK and NOK – weak on the widespread risk contagion and Friday’s CPI prints failed to excite interest. Would expect downside risks for NOK to intensify if crude oil drops through critical levels that are nearby on the charts as weaker EM’s are going to affect oil demand at the margin. Norges Bank announcement on Thursday.
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