All of this is playing out precisely like you’d think it would.
… is something I said on Wednesday evening, while writing breathlessly about the meltdown in Turkey and the ongoing turmoil in emerging market assets more generally.
And look, anyone who frequents these pages knows I’m loath to say “I told you so” or at least I’m not inclined to say it without quickly deploying some self-deprecating humor to soften the blow. I despise people writing in a non-professional capacity (e.g., bloggers) who say “I told you so” about anything, whether it’s economics, finance or politics, primarily because even if it’s accurate (i.e., even if you did predict something), nobody cares if you predicted it on a blog writing under a pseudonym. And that generalized lack of anyone caring isn’t mitigated by the number of people who read what you write. The simple fact of the matter is that if you’re writing in a non-professional capacity and you’re using a nom de plume, it doesn’t matter what you say because it’s impossible for anyone to verify whether you have any legitimate claim on an opinion.
With that caveat out of the way, I’ve been a little less shy about saying “I told you so” when it comes to Turkey and emerging markets more generally, for two reasons. First, I have a keen interest in Turkey for reasons I won’t elaborate on and I’ve been berating Erdogan and his policies pretty much every week since this site was founded a scant 18 months ago.
But more to the point, I don’t mind saying “I told you so” in this case because this was bound to happen based on the setup. Just ask poor Tim Lee, who predicted it five years ago, or just ask any macro strategist who’s been around for a while, or really, just anyone who has ever taken a graduate level economics course (that’s a category of people that includes yours truly, but not necessarily some of the other financial/economics blogs you might read). I’m just going to quote myself, from that linked piece about Tim Lee:
The tsunami of liquidity unleashed by developed market central banks in the wake of the financial crisis is in large part responsible for facilitating the kinds of imbalances that are now unraveling as that stimulus is rolled back. The mad scramble for yield catalyzed by post-crisis monetary policy sent investors scurrying down the quality ladder, leaving everything priced to perfection. Spreads on risky debt were (and in most cases still are) an illusion. Now that the Fed is tightening and dollar liquidity is disappearing, the carry trade is unwinding and the first casualties are showing up. Turkey is the first domino.
Period. There’s a lengthy take on this that draws on a sweeping new note from Nedbank’s Neel Heyenke and Mehul Daya in “Dollar Liquidity Dynamics: An Epochal Shift Is Coming, One Bank Warns“.
Well, in his latest note, SocGen’s incorrigible yet exceedingly affable bear Albert Edwards is out reiterating the extent to which the current situation was a no-brainer. In fact, he starts off by saying this: “There is no need for me to re-invent the wheel.” He then quotes his FX colleague Alvin Tan as follows:
A textbook currency crisis is unfolding in Turkey. Large and widening current account deficit, check. Growing foreign currency debt, check. High and rising inflation, check. Constrained monetary policymaking, check. Just as King Canute could not stem the waters by ordering the tide to stop, a country with a 6% current account deficit and 15% inflation will be powerless to stop its bonds and currency sliding without hiking interest rates and/or restricting capital outflows. The triggers may be unique, but the crisis in Turkey is all too familiar, and the required policy response is too.
There you go. Again, I don’t want to accidentally disparage anyone who hasn’t done post-graduate work in economics and certainly there are people with more experience in this than me who might not be PhDs, but what is unequivocally true is that you would be able to regurgitate the above assessment if you managed to stay awake during the first semester of a basic MBA program at even a mediocre university.
Anyway, Albert goes on to talk about the Fed’s role in tipping dominos and before I get to that, I want to just quote myself again from a Wednesday evening note:
Behind it all, the surging dollar, which rose for a fifth consecutive session on Wednesday to its highest since June 2017.
For months, I’ve suggested that late-cycle fiscal stimulus in the U.S. is putting the Powell Fed in a position where the committee has to hike in order to guard against the possibility that the Phillips curve suddenly reasserts itself, as it’s prone to doing in late-stage expansions. When you pile tariffs on top of that, you put the central bank in a real bind. Powell has been steadfast in his commitment to a data-driven policy regime, and he’s been even more adamant about expressing his upbeat take on the U.S. economy. That’s all dollar-positive, and speculative positioning in the greenback reflects those dynamics.
Until something breaks that cycle, the turmoil in emerging markets is likely to continue, because it simply is not possible for developing economy central banks to tighten policy fast enough and dramatically enough to offset Fed hikes without undercutting their own economies. That quandary is complicated immeasurably by the fact that the trade tensions threaten to undermine global growth. This week’s activity data out of China was lackluster, and the severe downturn in commodities reflects concerns about demand destruction. Emerging market economies are extremely vulnerable to that.
Edwards echoes that assessment.
“When the most important person in the free world starts lobbing macro hand-grenades in an effort to drain the swamp, the financial markets will always eventually react badly”, Albert continues, adding that “no” he’s not talking about Trump. Rather, he’s talking about Jerome Powell who is “draining the global liquidity swamp.” Here’s Edwards:
Make no mistake, whatever the macro-idiosyncrasies of Turkey, the key to the current turmoil that is spreading into EM generally, is Fed tightening and the strong dollar. As we have repeated ad infinitum, since 1950 there have been 13 Fed tightening cycles, 10 of them ended in recession and the others usually saw the EM blow up such as the 1994 collapse in the Mexican peso. The Fed always tightens until something breaks. It is usually its own economy, but sometimes it is the EMs. And when the liquidity tide goes out we always find out who is swimming naked. If it hadn’t been Turkey it would eventually have been someone else. The current macro-debacle in Turkey was widely predicted as foreign-denominated debt has soared and the current account deficit has remained stuck at 6% of GDP (see chart below).
Of course the reason Turkey’s crisis was so predictable this year comes back to Erdogan. The principle dictate of Erdogan-o-nomics is that higher rates cause inflation, an axiom so completely at odds with real economics that trying to wrap your head around it is an exercise in abject futility. If you’re interested in our handy pocket guide to this, I strongly encourage you to check out “Turkey In Crisis: A Narrative History And An Annotated Chart“, which traces the evolution of monetary policy in Turkey this year as Erdogan moved to consolidate power. For his part, Edwards sums things up as follows:
When you are relying on the kindness of strangers to fund the deficit, it is best not to try and invent a new form of economics in which the higher interest rates needed to restrain a rampant credit bubble and defend the currency are deemed politically unacceptable.
There’s a ton more in Albert’s full note, but the bottom line here is that the carry trade is unwinding and the environment that made 2017 so “synchronized” is rapidly changing. I discussed this at length in the context of a recent BofAML note in “Pondering ‘The End Of Synchronized Everything’“. In that post, I quoted my favorite sellside analyst, Deutsche Bank’s Aleksandar Kocic, who described the environment that persisted in 2017 as follows back in January:
Through their communication with the markets Central banks, and the Fed in particular, have become “good listeners” with their decisions and actions made with markets’ consent. After years of this dialogue, the markets have gradually surrendered to the ever shrinking menu of selections that converged to a binary option of either harvesting the carry or running a risk of gradually going out of business by resisting. Not much of a choice, really. In this process, Central banks have reached a point of enormous power and control where market dissent is practically impossible. We believe that such levels of market control remain uncontested with anything we have seen in recent history and that the markets’ dynamics have never been further from that of the free-markets. Low volatility is a perfect testimony of that.
On that note, I’ll leave you with one last quote from Edwards that kind of encapsulates this whole debate:
Lets face it: virtually everybody knew this was coming. But in the frantic QE-inspired hunt for yield, no-one cared. And this is always the problem while liquidity is washing through the financial markets because of loose money polices (usually centered around the Fed). Almost nobody is interested in heeding the pessimists and positioning of the inevitable financial market blow-up when eventually excessively loose monetary policy is belatedly tightened. Investors, drunk on the elixir of free money, think the good times will roll on forever. And even if they are cautious, a few quarters of underperformance usually invites either capitulation or being fired. With few exceptions, being too early with a bear call is usually a career ending decision. Better to stay in the crowd, remain fully invested and go over the cliff with the herd