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Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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EM FX Weekly: TRYing times
John J. Hardy
Chief Macro Strategist
We are writing this in the wake of the huge devaluation of the Turkish lira and an speech from Turkish president Erdogan indicating he will maintain his defiant stance and refuse to take the traditional measures of hiking rates or appealing to the International Monetary Fund for a bailout. The situation is very fluid and next week looks like a critical timeframe for the situation to move towards a resolution of one kind or another.
Helmets on
We leave this week with markets in a fragile state linked to the accelerating risk of a Turkish default, both by its banks and possibly even the sovereign eventually after Erdogan’s defiant speech. We’ll provide the normal full update next week. Until then we focus on two things – foremost, of course, the direction of the Turkish lira and whether any further weakness continues to feed additional contagion risk across EM and even into DM currencies.
The euro, for example, was weak on the risk to EU banks from exposure to Turkish banks. The other factor on the loose is the stronger US dollar, in part due to the Turkey-inspired sell-off, but also in the wake of the EURUSD sell-off through 1.1500. Further USD strength is generally associated with pressure on emerging markets, but extra attention on the USDCNY rate is also required as the Chinese currency’s level versus the dollar garners intense scrutiny and likely anxiety if the USDCNY is allowed to rise above 7.00 after China’s recent efforts to short-circuit further weakness.
The danger for Turkey is that at a certain level for TRY, the Turkish banks run out of excess capital to service debt denominated in foreign currency, debt estimated at 30-40% of Turkey’s GDP even before the most recent TRY devaluation. At a sovereign level, the default probability has moved beyond 25% according to CDS prices on Turkey’s sovereign debt – see in chart below.
President Trump added insult to injury on Friday with a tweet calling out bad relations with Turkey and a doubling of tariffs on steel and aluminum for Turkey relative to other exporters.
Chart: USDTRY and Turkey CDS price
There is no real technical analysis on a currency that is in freefall, but once the speed of the move turns parabolic as it has this week, the timeframe is likely rather short until some sort of at least near-term climax is reached. Next week looks like the time frame for the situation to reach some sort of temporary “resolution”.
Chart: Global Risk Index
A brief stay in positive territory indeed...
The recent thaw in risk conditions we noted last week has suddenly receded with the contagion risk emanating from Turkey, and conditions are worse than the chart is showing because not all indicators used to create the indicator provide intraday pricing, so the up-to-the-minute situation is worse than shown before.
EM currency performance: recent and longer-term, carry-adjusted
Chart: the weekly spot and one-month carry-adjusted EM FX returns versus USD: The Turkish lira’s weakness stands out as the chief mover and shaker in our universe of EM. The performance among EM currencies was rather varied recently until the last couple of days of the past week, where the acceleration of lira weakness began to feed contagion fears across EM. Somewhat adding to the broader contagion are flows out of the Russian ruble, where the sanctions threat from the US has picked up on the circulation of the leaked text of a proposed Congressional bill targeting Russia for its purported interference in the US election. A drop in oil prices could feed further RUB downside from here.
Chart: Three- and 12-month carry-adjusted EM FX returns versus USD: On the longer term performance chart, only MXN has managed a positive performance over the last three months as the market repriced the currency after a peak in pessimism on the prospects of an Obrador presidency back in June. Meanwhile, the damage done to Turkey via its currency will mean ugly real economic pain as the costs of imports have risen precipitously and as credit is cinched off as banks lick their wounds. Any boost to exports from a cheaper currency will not offset this pain significantly.
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