Emerging Markets are front and centre of traders psyche once again as the relatively contained crisis in Turkey and Argentina spreads more broadly - or at least traders worry it will.
In no small part that might be because central bankers in EM countries are now themselves warning of the pressure that they find themselves under.
In what might end up being the own goal of the year Reserve Bank of India governor Urjit Patel shined a light on his concerns that the Fed’s plans to continue reducing its balance sheet along with the prospect of further rate hikes and the funding task required for the US deficit could cause further ructions in EM currencies and bond markets.
Earlier this week, before the RBI raised rates a quarter point to 6.25%, Patel penned an Op-Ed in the FT titled Emerging Markets face a dollar double whammy.
In that piece Patel called for the Fed to halt its balance sheet reduction – QT – writing that the upheaval in emerging markets was a result of (my bolding), “the coincidence of two significant events: the Fed’s long-awaited moves to trim its balance sheet and a substantial increase in issuing US Treasuries to pay for tax cuts. Given the rapid rise in the size of the US deficit, the Fed must respond by slowing plans to shrink its balance sheet. If it does not, Treasuries will absorb such a large share of dollar liquidity that a crisis in the rest of the dollar bond markets is inevitable”.
That's something the RBI then alluded to in its statement after the decision on interest rates this week when it said, “bond yields have risen on reduced foreign appetite for their debt due to growing dollar shortage in the global market and on prospects of higher interest rates in AEs (advanced economies)”.
Indeed you can already see the pressure in the moves in emerging currencies.
The chart below shows the weekly moves in USDTRY, USDBRL, USDZAR, and USDINR - that is the US dollar against the Turkish lara, Brazilian real, South African rand, and Indian Rupee. It's clear they have all - to varying degrees - been under pressure.
So maybe it's not an own goal by RBI governor Patel but simply an honest statement of reality. Of what is in fact happening in emerging markets right now.
Germane to that point is a question I asked last night - and why I thought this note might be timely - about whether the $4 billion in outflows from Asian equities in May, the fourth month in a row of net selling, would continue.
As a behavioural economics and finance guy my answered was pretty straightforward and framed through that lens.
And the reality is that as trite as it may sound at the core of outflows is fear of loss by traders and investors who have piled into EM markets in the era of QE.
Money flows into EM currencies, bond, and stock markets because investors see an opportunity to earn returns over and above those in developed -or other - markets.
The outflows are happening because opportunities are opening up elsewhere, especially in the US where Fed tightening, rising rates, a strengthening dollar, and quantitative tightening have all combined to put pressure on deficit, or politically challenged, EM nations.
That pressure is spreading beyond the obvious countries to a broader set of EM economies.
And it's not just the Indians complaining. Of course we know Turkey's troubles, Argentina has just this morning inked a deal with the IMF, and, according to Zerohedge, new Bank Indonesia Governor Perry Warjiyo has also called for a similar halt to the Feds balance sheet tightening.
I've always felt it was folly for the Fed to assert that even though QE was the tide that lifted all boats in markets and then by extension gave the real economy the room to heal, that the unwinding of the balance sheet, it's quantitative tightening program, would go off without a hitch.
So as the Fed winds down its balance sheet $20 billion a month this year and $50 billion next year then as Gillian Tett said in the FT overnight that's a, "cumulative $1tn of liquidity by December 2019," which could in turn "creates a dollar liquidity squeeze".
That whats worrying Patel, Warjiyo and others.
At the moment, of course, the Fed looks set to both continue to tighten rates and pursue its Balance sheet reduction plans - QT - in the year/s ahead. And of course, the US Treasury will continue to have its monumental funding task which will continue to soak up US dollars from at home and abroad.
So the pressure looks set to remain on EM currencies while the confluence of a string US economy drives the Fed Funds Rate and the US dollar higher.
The question on my mind though is when does this move in emerging markets and the pressure they are increasingly coming under morph into broader concerns about markets across the globe.
There is no need that it should. But there is a big chance that it might.
Watch this space folks because if EM does get funky the Yen, the Aussie, long bonds across the globe, commodities, and stocks will all come under pressure.
My guess is this is pribably a 30-35% cahnce on a 6 month time horizon at the moment.
Time will tell.
Have a great day's trading.
Chief Market Strategist
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