EM risks rising as we can’t find a pulse for the USD

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The initial relief that populists parties failed to make as much headway in the EU parliamentary elections as mainstream parties feared has yielded to a general worry that the lack of a clear majority at the centre could risk leading to political paralysis – always an EU vulnerability. The euro is perhaps offered at the margin on the uncertainty as to what degree the EU can appoint the leadership necessary for the EU to get ahead of its existential challenges in the coming cycle.

France’s Macron is gunning for a pro-Europe visionary for European Commission President (to replace Juncker) who can build a majority across the party lines and is clearly against German “Spitzenkandidat” Manfred Weber, who remains strongly backed by Germany and is the leader of the EU Parliament’s largest party, the centre-right EPP.

In Italy, Salvini is talking tax cuts and railing against EU budget rules, which has seen Italian BTP yields spike back higher after an initially supportive reaction to the election result early yesterday. EURJPY looks the preferable way to trade a weakening euro, as long as global bond yields remain weak (yesterday saw German 10-year bunds close at their lowest for the cycle at -14 basis points, only a few bps above the record low from 2016).

Finally, another angle of risk for the EU is the risk of a trade policy row over autos with the US, with risks escalating now that the EU  has drawn a red line on refusing to allow any quota system. A sharp response/tweet from the US side could further escalate the situation.

EM risks picking up again

We are seeing a more notable pickup in EM spreads though they remain modest compared to the episode in Q4, a development that is in tune with the general weakness across EM equity markets and concerns for global growth. The weakest link is Turkey, where the government is in a last-ditch effort to shore up its currency defenses and point to the risk of eventual capital controls. Turkey is now requiring banks to up foreign FX reserves and mandating that pension funds place 10% of funds in the Turkish equity market and 25% in Turkish government bonds. Turkish CDS prices (insurance on Turkish sovereign debt) has risen back above 515 in recent days, only some 60 points below the worst levels during the lira crisis late last summer. 

Chart: EURJPY

EURJPY is looking heavy again and could plumb new depths if risk sentiment remains in the dumps and European yields head lower still, with German bunds poised near the all-time lows. The downside looks rather open here with few downside anchors besides the former major cycle low at 110.