We noted a week ago that risk markets, EM currencies and the euro had started to bounce back as the Turkey-crisis had come off the boil. They remained in good form in the past week, under the helpful additional influence of (i) a Powell-speech towards the end of last week that was perceived in some quarters as moderately dovish, (ii) CNY appreciation engineered by the Chinese government, (iii) a strong IFO business climate observation in Germany, and (iv) completion of a trade deal between the US and Mexico. In the minds of risk-market investors, all of these factors more than offset the negative impulse that comes from last week’s quick death of the US-China dialogue on trade. Forward-looking, however, we think the risk is weighted towards renewed EM asset price underperformance as we see a high likelihood of new and negative twists in the relationship between the US on the one side, and China and Turkey on the other.
That’s from an emerging market strategy note from Credit Suisse dated Wednesday. The title of the note: “A bounce that cannot be trusted”.
For all of the reasons outlined in that excerpted passage, emerging market assets looked like they might be set for an extended reprieve. The dollar was finally on the back foot following Trump’s renewed attacks on the Fed and Jerome Powell’s contention in Jackson Hole that inflation in the U.S. shows “no clear sign of an acceleration above 2 percent, and there does not seem to be an elevated risk of overheating.” Meanwhile, the PBoC moved in for the kill on yuan bears that had already been squeezed earlier in the month. Turkey instituted a series of measures designed to stanch the bleeding in the lira and the U.S. and Mexico struck a tentative bilateral trade deal that appeared to set the stage for Canada to rejoin NAFTA talks.
Then, on Wednesday, it all started to unravel. The Argentine peso collapsed as President Macri’s request that the IMF accelerate disbursements spooked the market, prompting an emergency rate hike a day later.
Goldman annotates the peso’s collapse
The lira tumbled anew this week as well once the market came to the realization that nothing has changed in Turkey. In fact, the tension between Washington and Ankara has only grown, with the U.S. declining to make concessions on Halkbank and Turkey refusing to budge on detained Paster Andrew Brunson.
On the trade front, Bloomberg reported Thursday that Trump is set to move ahead with tariffs on an additional $200 billion in Chinese goods as soon as next week, the most serious escalation yet in the trade spat between Washington and Beijing. And on Friday, talks between the U.S. and Canada broke down, throwing the future of NAFTA into doubt (again).
There was a bit of relief to close the week, but all told, this was a miserable month for emerging market FX.
The pain was widespread. In addition to the bloodbath in the lira and the Argentine peso, the Indonesian rupiah hit its weakest against the dollar since 1998, the Indian rupee hit a record low and the rand came under immense pressure (one-month historical volatility on ZAR surged this month).
“In our opinion, the dollar rally of 1H18 has put the weakest balance sheets (Turkey and Argentina) under pressure [and] the next dollar bull run could spread like a wild fire through the Asian economies and capital flight back into the US bond market is likely” Nedbank’s Neels Heyneke and Mehul Daya wrote, in a note dated Friday. “We believe that all EM currencies (including the rand) will be in the firing line”, they add.
The MSCI Emerging Market currency index has fallen for five consecutive months, the longest streak since September 2015 following the yuan devaluation.
August marked a continuation of the ongoing malaise in developing economy assets. Q2 was the worst quarter for EM stocks and FX since 2015 and markets now fear that further escalations in the trade wars and a resumption of dollar strength could undermine the space further.
In bond land, U.S. junk now trades tighter than the Bloomberg Barclays EM Sovereigns index, a testament to how risky folks think developing economies now are.
Credit Suisse and Nedbank are hardly alone in predicting more pain to come. On Wednesday, Credit Agricole suggested that the mid-August relief in EM was likely to prove fleeting. In a note, the bank’s Sebastien Barbe cited the probability of renewed pressure on the lira and the prospect of additional tariffs on China as cause for concern.
You can draw your own conclusions here, but the bottom line appears to be the same as ever: it’s going to take a sustained move lower in the dollar and an convincing abatement of trade tensions to stabilize this situation.
For what it’s worth, USD net long positioning slipped $0.3 billion to $24.7 billion overall in the week through Tuesday, but clearly, the market is betting on the greenback’s run to continue…