Somewhat Restrictive

Said Evans, if I were predictive
A setting that’s somewhat restrictive
Might be just the thing
To slightly hamstring
This growth that’s become quite addictive

Chicago Fed president Charles Evans, a reliable dovish voice on the FOMC, spoke yesterday and made news because of his more hawkish tone. “If inflation [PCE] continues to be on the order of 2, 2.2 (percent) — I’m not expecting it to get as high as 2.5 — that suggests only a modest amount of restrictiveness above our neutral rate might be called for in 2020,” he said and continued, “ It would not surprise me at all if we make a judgment to move to a somewhat restrictive setting.” For a dove, that is a remarkable admission of the strength of the economy and the growing belief that monetary policy is now sending the wrong signals.

Remember, despite the fact that the Fed has raised rates seven times for a total of 175bps since December 2015, Fed funds remain well below the inflation rate so real interest rates remain negative. In fact, this morning we will see just how far below as CPI is due to be released at 8:30 and expected to print at 3.0% with the core rate at 2.3%. Historically, real interest rates have been positive to the tune of 2.0% and while there have clearly been fundamental changes in the economy that may warrant a lower real interest rate (e.g. technological advances driving efficiencies, globalization), negative real rates are only called for during a recession or worse. If the doves are now on board the rate raising train, and these comments seem to suggest that they are, the Fed could become even more aggressive in 2019, with a press conference after every meeting, and therefore the opportunity to explain their actions. Don’t be surprised if they raise rates in January 2019 especially if the emerging markets don’t completely crater. And if you want a hint of how this will impact the dollar, last night’s price action, with the DXY rising 0.5% and the euro finally breaking out of its recent trading range, falling by a similar amount, are very good prognosticators.

But the caveat is, if the emerging markets don’t crater, and that is an important caveat. Last night, the Turkish lira saw a significant escalation in the recent market tension as it fell nearly 10% at one point and though it has recovered slightly, remains down by 7% as I type. The thing is, nothing new has been revealed. It appears that as the week is drawing to a close, traders and investors are simply coming to the conclusion that President Erdogan is not going to allow the central bank the leeway it needs to manage the economy in an orthodox manner, and that things could well spiral out of control. The fact that Turkey and the US remain at odds over the arrest of an American pastor by Istanbul, and that sanctions are being imposed, is just adding fuel to the fire. This is the proverbial falling knife. Don’t try to catch it. Until the politics changes, the currency is likely to continue in freefall.

The question is, will this infect other emerging markets, and by extension developed country markets? If last night is any indication, it may just be starting to do so. Equity markets throughout Europe are lower, some pretty sharply (Germany -1.5%, Italy -1.7%) as concerns have been raised over some of the large European banks’ exposures to Turkey. We saw weakness in Japanese equities (-1.3%) despite the fact that GDP growth there in Q2 was shown to be a better than expected 1.9% annualized. US equity futures are also softer, down about 0.5% at this point, and Treasury yields are falling (10yr -4bps) as investors are fleeing to safe havens. In other words, it is beginning to look like that infection is starting to spread.

As is often the case, these concerns make themselves known in almost random fashion. Certain currencies respond to the news in a negative way, while others that you may assume would see the same type of response don’t move. It is also important to watch the movement over a week or two, rather than on a given day, as those trends can be more revealing. For example, RUB is barely softer this morning, down just 0.3%, despite increased sanctions imposed by the US because of the poisoning of an ex Russian spy in London earlier this year. But this week it has fallen 5.6%, a pretty hefty move, and indicative of the fact that there is growing concern there. Another currency feeling the pressure this morning is ZAR, which has fallen 1.1% and 4% on the week. But as it had strengthened sharply through Q1, it is only down 2% in the past year. However, the recent trend is ominous and it certainly appears that ZAR has further to fall. MXN is another interesting case, where it has fallen 1.25% overnight and 2.6% this week, but remains far stronger than its levels earlier this summer in the run up to the presidential election there. However, regardless of the market’s relief that AMLO does not seem to be as radical as initially feared, emerging market disease can be quite contagious, and it would not surprise me at all to see the peso fall another 5% or even more if we see additional pressure elsewhere.

The key to remember here is that there is a great deal of herd behavior demonstrated by investors, especially emerging market investors, and if they start to leave one market because there is fear of a serious problem, it can easily spread to other markets, especially if liquidity in that first market dries up. We have been witnessing individual market problems all year, and each one seemed isolated due to specific local events. But I am getting the feeling that we may have reached a tipping point, where there have been enough individual events to cause a re-evaluation of the general trend. If this is indeed the case, then the Fed may well slow the pace of its rate hikes, but the dollar should benefit anyway as the safest haven of all.

Do not be surprised if we see wider spread weakness across emerging market currencies going forward, and by extension, the G10 as well. There are likely to be two exceptions to this rule, JPY and CHF, but otherwise, I fear thin summer markets may lead us to some larger moves across the board. So stay alert and maintain those hedge ratios.

Good luck and good weekend