Post date: 13/08/2018 08:00
A classic emerging market crisis slammed currency markets last week. The Turkish Lira crashed as President Erdogan and his financial advisers appear to be losing control of the situation and make increasingly bizarre and unhelpful statements. The Euro had managed a modest rally earlier int he week, but quickly gave it all back as markets started to worry about the impact of the Turkish crisis on certain European banks and the Euro zone economy in general. The dollar, Swiss Franc and Japanese Yen all outperformed buoyed by investors in search of safe havens. Latin American currencies, the Ruble and the South African Rand suffered the most in knock-on effects from the Turkish crisis.
Next week is shaping up as a crucial test for emerging market currencies. The key question is whether the Turkish crisis will be seen as an idiosyncratic event driven by Turkey’s specific vulnerability and financial mismanagement, as we expect, or whether investors will use it as an excuse to pull out of other emerging markets as well. Economic news flow, by contrast, will be quite limited so expect markets to be driven by political headlines, particularly out of Turkey.
Earlier in the week, Sterling continued its recent trend and weakened modestly as traders fretted about the possibility of a hard Brexit. However, later on the Turkish crisis dominated headlines and Sterling managed to rebound against the Euro, given the minimal expected fallout for the UK economy and banks. This week we will see some critical economic news out of the UK. Labour data on Tuesday and the inflation report out on Wednesday would ordinarily dominate Pound trading, but it remains to be seen whether this news can make itself heard above the Turkish din.
Reports that the ECB is closely following the impact of the Turkish crisis on certain European banks (BBVA, Unicredito and BNP primarily) slammed the Euro late last week, sending it below the 1.15 level that had been a de facto floor since the summer of 2017. We think that market reaction is excessive. Exports to Turkey amount to less than 0.5% of European Union GDP. As for the impact on European Union banks, the very worst case scenario would be for them to walk away from their investments in Turkish banks. Even in the most exposed case, BBVA, this would amount to a significant loss but one that can easily be absorbed by the bank’s capital buffers. At current levels, we are starting to see the selloff in Euro as excessive, though we think the timing is not quite right yet to go long the euro vs the US dollar.
The mayhem from Turkish markets obscured what we think is a very important data point out of the US. The inflation report on Wednesday was stronger than most analyst expected. Critically, the core inflation data edged up again to 2.4%, clearly above the Federal Reserve’s target and showing no signs of stopping its slow upward trend. US interest rates reacted to the news by ticking up noticeably, but the move was swamped later int he week by waves of safe-haven buying of US treasuries in reaction to the Turkish mess.
Next week data is thin in the US so we expect dollar moves to be driven primarily by headlines on both the Turkish situation and headlines from Trump Administration’s trade spats with the rest of the world.