Are the Turkeys coming home to roost?

September 24, 2020 • Estimated Reading Time: 10 minutes

It's all been dollar talk recently here at Macrodesiac.

And rightly so.

The dollar rules king.

But while we've been focused on USD, I reckon it's right to look at what a rising dollar could cause...

Just a recap of where we lie with the dollar index first though...

TradingView

We've seen a really vigorous rally over the past week or so to break that key level at 93.90, and naturally, since the euro makes up about 57% of the index, our euro trade has really come off nicely...

Finally.

As I mentioned a few days ago, it seems as if it's down to tightening conditions that the dollar is rallying, as well as the Fed not actually expanding the balance sheet as much as perhaps the market would like (all of that liquidity is getting gobbled up by Treasury issuance and not by market participants)...

Naturally, this creates a situation where risk isn't favoured and investors look for dollar safety.

But what does this mean for emerging markets?

Well, let's take a look at $EMHY (The Emerging Market High Yield ETF).

It's seriously taken a pasting whilst the dollar has been rallying.

See, a lot of these corporates in emerging markets will have dollar denominated debt...

And as the dollar increases in price, their debt becomes worth less.

Naturally this has an adverse effect on the bond price and then their default risk.

And even if it's local currency denominated, risks come about due to a depreciation of the currency versus the dollar.

It's always a dollar story.

Looking away from corporate debt markets, I want to focus on Argentina.

Naturally, this is a country which has had many sovereign debt issues, and has constantly needed restructuring and financing from the IMF to stay afloat.

 I don’t think ‘Argentina’ and ‘successful debt restructuring’ go well together. https://t.co/yDsxXAcXy6— David Belle (@macrodesiac_) September 19, 2020 

Argentina recently imposed capital restrictions, leading to Argentines withdrawing small dollar holdings from bank accounts.

Bloomberg

Again, we see the flight to safety of the dollar.

What would concern me going forward is a real sustained strengthening of the dollar - this is coming from an economic perspective and not so much a trading perspective...

As traders, we probably shouldn't have a moralistic outlook on what markets do, otherwise we'd hardly do anything.

Just so you understand the extent of the currency crisis in Argentina, here is USDARS.

Mental.

Back in 2001, there was a similar crisis.

If you want to be a doomsayer and say that we're in a similar period then I wouldn't begrudge you that.

2001 was when the world was coming out of the DotCom boom and I guess there are some parallels that could be made with then and now, especially with debt burdens being so high (even higher now).

Back then, though, there wasn't the central bank liquidity provisions that we have over this post GFC regime, so that is one key differentiator.

My concern here would be that other emerging market countries end up following the same path as Argentina...

Not to the same extent, because I feel like Argentina is a rare case, but it's a case study in how certain dynamics can contribute to excessive stress in an economy and practically break it.

So what am I looking at?

You'll know if you've been with Macrodesiac for a while that Turkey is certainly an economy that I reckon has big risk contained in it.

They have political issues (like Argentina), economic issues (high inflation at 11,77% at last reading, and a President that wants to lower interest rates) and a seriously depreciating currency...

Back in 2018, Turkey also faced a currency crisis, but were prepared to respond then by raising the base rate...

This time, Erdogan is strongly against rate hikes - today, it's expected that the Turkish Central Bank will keep rates unchanged...

Here's what Jason Tuvey from Capital Economics had to say.

This time, though, the central bank’s response has reinforced concerns about the policymaking environment in Turkey. Admittedly, the CBRT has tightened monetary conditions in recent weeks, with the average cost of funding rising by more than 325bp, to 10.61%, since mid-July. And it seems increasingly likely that the CBRT will shift all funding for commercial banks to the late liquidity window, which marks the top of the rate corridor with an interest rate of 11.25%.

But there are no clear signs that the CBRT is willing to tackle the inflation problem head-on. The central bank seems loath to hike official policy rates due to pressure from President [Recep Tayyip Erdogan]. Even if nominal interest rates hit the top of the corridor, real interest rates will remain negative—headline inflation stood at 11.8% y/y in August. In 2018, real rates were pushed into positive territory. Policymakers’ shift in focus towards maintaining a ‘competitive’ lira suggests that they are now more willing to let the lira weaken.

One large problem for Turkey comes from its widening current account deficit.

The current account is essentially a record of a nation's transactions with the rest of the world.

A widening current account in this case means that less is being bought from Turkey than is being imported.

That implies a net outflow of domestic currency, leading to a depreciation.

Another currency issue is to do with Turkey's FX reserves.

Here's a quote from the FT on this.

The Turkish central bank sharply increased its borrowing in February through short-term swap operations that it uses to exchange lira with local banks in return for dollars, according to data released on Friday. This brought the total outstanding amount of money borrowed through such operations to $25.9bn at the end of last month.

In comparison, net foreign assets — a measure of net reserves that is reached by subtracting foreign currency liabilities from assets — were $27.4bn. Once the short-term borrowing is deducted, that figure is just $1.5bn, which analysts say is insufficient to tackle any large declines in the lira.

In my view, if Turkey do not raise rates, they are in for significant trouble.

A rising dollar is seriously not in their favour.

And we can see this through how their 5y CDS (credit default swap) has risen in price after the dollar's recent sharp rally.

WorldGovernmentBonds.com

And what does this imply?

The Turkey 5 Years CDS value is 557.5 (last update: 23 Sep 2020 21:45 GMT+0).

This value reveals a 9.29% implied probability of default, on a 40% recovery rate supposed.

CDS value changed +8.81% during last week, +0.18% during last month, +51.74% during last year.

And just for reference, we'll take a broader timeframe view on this.

Not looking pretty, is it?

A big danger that I see is that the Euro area is Turkey's largest export base.

Europe is facing heightened corona virus cases, and whether you think it's right or wrong, European governments are on high alert and are seemingly happy to be a bit punitive with the whole 'closing down economies' thing (I'm looking at you, BoJo)...

This is naturally a large dampener on demand...

So with this, attention must squarely be on European banks if the Turkish situation worsens drastically.

Spanish financial institutions should hope that the situation in Turkey will stabilise.

At stake for them is $62 billion.

French banks are involved with $29 billion.

British banks record in their balance sheets loans to Turkey of more than $12 billion, while German banks are involved with about $11 billion dollars.

Italian banks have invested about $8.7 billion.

These are not small sums, especially for Spanish banks.

At risk here would likely be BBVA.

The crazy thing to me is that they report a strong capital adequacy position of 17.4%...

Well, the firm's share price doesn't reflect such a rosy story...

We made all time lows this week.

My view here then is that if there is some sort of contagion, the euro could have far further to run than first thought.

But it's all dependent on the dollar.

Sustained dollar strength should be the theme for the rest of 2020.

But beyond that, something will have to break for the above to become apparent.

How that could break remains to be seen, but the issue always stems from liquidity, and that is being provided in relative abundance for now.

However, perception is also key and social unrest is something that I don't think markets are able to price in enough.

If the Turkish situation worsens, alongside global demand remaining stagnant, I do see trouble ahead for the Turkish economy.