Increasing Doubt

When viewing the world as a whole
While most of it’s been on a roll
Five nations stand out
For increasing doubt
Their future’s are under control

It began with Argentina, moved to Turkey and has now spread to Indonesia, India and Brazil. I’m speaking, of course, about the increasing market turmoil in each one of these nations. They all share certain characteristics; each is running a significant current account deficit, each has seen inflation pick up (in some cases quite significantly) and has been forced to raise short term interest rates to counter growing instability in their currency markets, and each has seen outflows of capital by international investors. While the situation has not yet reached the point where contagion is clear, the fact that there are now five countries feeling similar pressures is somewhat disconcerting.

It was roughly twenty years ago when we saw our last EMG crisis (starting in Thailand in 1997, spreading throughout Asia that year and then into LATAM and EEMEA in 1998 and culminating with Russia defaulting on its debt.) It was not a happy time for investors and it certainly was not a happy time for citizens in those countries. This begs the question, are we beginning to see the same type of scenario unfold? On the one hand, EMG countries learned a key lesson then and have all built up much greater FX reserves to help them support their currencies in times of stress. On the other hand, almost every EMG nation, as well as many companies based in those nations, have been funding themselves in the USD market because of the artificially low interest rates available due to Fed monetary policy. In fact, that financing has grown to be over $2.7 trillion. And that offers a different avenue down which contagion can spread.

Now that the Fed is tightening monetary policy by both raising interest rates and reducing the size of their balance sheet, these borrowers are feeling significant stress. And that stress is reflecting itself in weakening currencies. It has become a vicious cycle; higher US rates draws investment back to the US causing capital outflow and a weaker currency, which puts greater stress on those nations’ ability to repay that debt. Of course the weaker currency leads to higher inflation, which drives higher local interest rates which slows the growth cycle in those countries. And that encourages further capital flight and more currency weakness, starting the cycle all over again.

So far we can still count the problem countries on one hand, but with Brazil now added to the mix, we have run out of fingers. This matters to us all, not because we are necessarily invested there, but because of the possible impact it will have on Fed and other G10 central bank thinking. In fact, there has been a pattern recently of the central bank governors of these nations speaking out against the Fed continuing to tighten policy. If the Fed raise rates each quarter this year, my take is that we will need more than two hands to count the countries that are feeling the stress, and that the consequences for global markets will not be positive. So despite last month’s speech by Chairman Powell, where he dismissed the idea that emerging market economies were suffering solely because of Fed policy, it strikes me that the Fed’s reaction function may be forced to change before the year is over. Perhaps rates are not going to go as high as I had previously expected, although inflation still seems like a safe bet to continue rising. However, if this scenario plays out, where the Fed is forced to stop tightening policy because of an EMG crisis, the dollar will still be the beneficiary of a major risk-off event. While I am not forecasting this outcome, I think it is critical that we be aware of the potential for more market volatility because of this situation.

Enough doom and gloom. This morning we are looking at the dollar’s continued correction lower from last month’s strong rally. Despite weak German Factory Order data (-2.5%), the market seems far more focused on the Praet comments from yesterday about the timing of the ECB ending QE. In fact, there were far more articles on the subject today than yesterday. And it has been the driver behind the euro’s 0.4% rise this morning. Meanwhile, the pound has given up its early gains, which were based on higher than expected housing prices, on the news that PM May is trying to quell a battle within her cabinet regarding Brexit. My take from 3000 miles removed is that the problems are intractable and that we are going to see PM May’s government fall and new elections with a new weak PM, Jeremy Corbyn. While my head tells me that this should be a Sterling negative, I have a suspicion that the market will respond to his softer approach to Brexit and actually push the pound higher. But this will likely take a few more weeks, if not months, to play out. In the meantime, I continue to believe that the BOE will be unable to raise interest rates, and the pound has only limited upside for now.

The other story that is getting a lot of press is the G7 meeting that starts tomorrow in Ottawa. The US decision to impose tariffs on imported aluminum and steel from Canada and Europe on national security grounds has resulted in a great deal of pre-meeting commentary by the leaders of all six of the other nations. And rightly so, as they are all clearly US allies and have been for decades. But given that the tariff story has been ongoing for months, it strikes me that there is very little new impact likely from this situation. For FX hedgers, it is just not that important.

Yesterday’s US data showed that oil exports reached a record and the Trade deficit was a smaller than expected -$46.2B. Alas, productivity rose only a scant 0.4% while Unit Labor Costs rose a more than expected 2.9%. Those are not great numbers for the economy, but as we have seen consistently in Q2, risk continues to be added to portfolios with increasing abandon. This morning’s only data point is Initial Claims (exp 225K), and the Fed is in its quiet period ahead of next week’s meeting. All that adds up to the likelihood of a pretty quiet session in the G10 space. Of greater concern will be how the EMG space behaves, especially BRL, which has been depreciating about 2% a day for the past several sessions. If USDBRL should reach 4.00 (currently 3.85), I fear we may see the beginnings of more EMG contagion. However, right now, USD consolidation seems the most likely outcome.

Good luck