Fowl Play? The Twisted Linguistics of Turkey
American turkeys and African guinea fowl, victims of Portuguese vagary, became inextricably mixed. Today the geographically garbled turkey is known as dinde (from poule d’Inde or chicken of India) in France, kalkoen (from Calicut hen) in the Netherlands, and indjushka (Indian bird) in Russia. The Turks, who knew it didn’t come from Turkey, called it hindi (from India). In Levantine Arabic, it’s known as dik habash (Ethiopian bird); in Malaya, ayam belanda (Dutch chicken); and in Cambodia, moan barang (French chicken). The Albanians, who hedged their bets, call it gjel deti (sea rooster).
– National Geographic
Fascinating to watch the younger market pundits declare the worst is over for the emerging markets.
The worst? NFW!
Temporarily oversold? We fully agree.
U.S. Monetary Policy
The dollar monetary tightening is the receding tide exposing those emerging market economies who have been swimming naked. Thus far, Turkey and Argentina have been caught in their birthday suits.
More Tightening Coming
It’s about to get worse, not better, folks.
The rollover of the Fed’s maturing Treasury portfolio into the monthly 2,3,5,7, 10, 30-year notes and bond, 2-year FRNs, and 5-10-30 TIP auctions begins to drop-off significantly starting in September. That is very little Fed participation in Treasury auctions going forward. The Fed SOMA portfolio recently took down 11.85 percent of the 10 and 30-year auctions just last week.
The diminishing participation of SOMA as the funding needs of the U.S. government increase due to the explosion of the budget deficit, ceteris paribus, should put significant upward pressure on long-term interest rates.
Of course, safe haven inflows into the Treasury market in the event of a macro shock could upend our interest rate expectations. Moreover, the net short position in Treasury futures is at record levels and vulnerable to a short squeeze.
But that has been the case for quite awhile. Short squeezes are technical and by definition short-term in nature, and the crowd is sometimes right.
Thus, while economists and investors obsess daily over the flattening yield curve, we are are looking for it to begin steepening as it has been artificially flat and distorted by QE, both at home and abroad.
On The QT
Moreover, the Fed’s quantitative tightening cap steps up from $40 billion per month ($24 billion = Treasuries and $16 billion = MBS) to $50 billion ($30 billion = Treasuries and $20 billion = MBS) in October. That is the Fed will be draining a maximum of $50 billion per month of dollar liquidity starting in Q4.
Granted most will come out of excess bank reserves, but monetary policy is a complex and complicated beast. Nobody fully understands the consequences of the Fed’s actions and can pinpoint precisely the impact and timing on capital flows. This applies as much to the monetary authorities as it does to Joe Sixpack and Mrs. Watanabe.
In other words monetary policy has always been and always will be a black box. Now more than ever as we are in the uncharted territory of unwinding quantitative easing. Indicator species become that more important to detect changes in the financial ecosystem. Emerging markets and commodities have traditionally been the first to suffer physical deformities when the global monetary screws begin to tighten and become binding.
Thus far, the drain of liquidity from the Treasury market is relatively close to the projective cumulative cap — $132 vs $131.6 billion actual (end-July). The SOMA MBS portfolio reduction is running only about 60 percent of the cumulative QT cap, which began last October, probably due to the erratic nature of the maturities of mortgage securities with prepayment uncertainty. The MBS portfolio has shrunk by $53.6 billion (end-July) versus the projected maximum of $88 billion.
63.4 percent Cum Probability of a 50 bps Higher FED Funds Rate By December
Then there are the further interest rates hikes to come. The markets are estimating a 96 percent probability the Fed hikes another 25 bps in September and a 66 percent probability of another 25 bps in December to a Fed Funds target range of 2.25-2.50 percent by year-end.
Nice interactive table from Reuters BreakingViews on EM countries with macro vulnerabilities similar to Turkey.
Resembling Turkey is a problem right now. The lira’s alarming slide has made investors wary of any emerging country that shares too many of the same economic and financial vulnerabilities. The most similar, such as South Africa and Argentina, are already hurting. But even those with a less striking resemblance are vulnerable as capital flows out of riskier markets.
Breakingviews has identified some of the economic problems afflicting Turkey and ranked other emerging markets according to how vulnerable they are on the same counts. These difficulties include big budget and current account deficits, inadequate foreign exchange reserves, and too much debt issued in foreign currency. A relatively high proportion of overall debt held by outsiders is another weakness. – Reuters BreakingViews
It pains us to see Chile ranked so poorly as we worked on the country’s structural adjustment programs in the late 1980’s, and watched it become the superstar emerging market for 25 years. We suspect this is largely the result of being caught up in the trade wars and collapse of copper prices. We need to drill down deeper at the country level.
Feels Like 1997
We hope you had a chance to read our post, Feels Like 1997. It gives a good background on the current turmoil in emerging markets in the context of the 1997 Asian Financial Crisis. We also explore the danger of weaponizing capital flows.
Is The U.S. The “Ultimate” Emerging Market
Because the U.S. so dependent on external financing, we believe the use of capital flows as a weapon and tool of achieving policy goals will certainly backfire and eventually turn on the United States.
In fact, Adam Posen writes FDI into the U.S. has fallen to zero.
Beyond the cost of President Trump’s trade war with longtime US friends and rivals, his policy of economic nationalism has taken a toll in another important sphere: Net inward investment into the United States by multinational corporations—both foreign and American—has fallen almost to zero. As I pointed out in a posting in Foreign Affairs this month, this shift of corporate investment away from the United States will decrease long-term US income growth, reduce the number of well-paid jobs available, and accelerate the shift of global commerce away from the United States. – Adam Posen, IIE
Are portfolio flows into the Treasury market next?
Turkey dropped off the U.S. government’s list of major owners of Treasury debt, following in the footsteps of Russia in reducing its portfolio.
Turkey’s holdings of bonds, bills and notes have fallen 42 percent in the first half of this year, dropping to $28.8 billion in June, according to a Treasury Department report released Wednesday. Treasury has a floor of $30 billion to be classified as a major holder. – Bloomberg
It is difficult to definitively conclude that a country selling off it Treasuries is retaliation or financial weaponization. Economies with balance of payments difficulties, who are forced to intervene in their FX markets to prevent a currency collapse, by definition, suffer a reduction in international reserves, which are usually held in Treasury securities. Ergo their holdings of U.S. Treasuries decline.
A little sidebar.
The reduction of international reserves in the emerging markets, the largest component of the global monetary base, is the major reason why we believe the gold price has been falling and continues to decline. See here to understand what many consider the surprisingly poor performance of gold in the current environment.
The Limits Of Quantitative Easing As A Bailout Mechanism
Nevertheless, the demand for a currency, even if it is the reserve currency, is not infinite nor is it permanent. American voters and policy makers need to put the country on a sustainable political and fiscal path, and do it soon. That is possible but not probable without a crisis.
Don’t count on the Fed retreating from its tightening policy or bailing out the emerging markets just yet. Not until the glass really begins to shatter.
Raghuram Rajan, former governor of the Reserve Bank of India, in an interview with CNBC, said the Fed isn’t in a position to hold off on rate hikes.
“In 2013, when we had the last bout of volatility, the Fed stayed off raising interest rate for some time. It is not clear it can do that right now because we have inflation numbers in the U.S. gaining strength,” said Rajan, who in 2005 went to the Fed’s Jackson Hole retreat and warned that the global economy faced the risk of a meltdown from risky behavior in the financial sector.
“At this point, it seems to me the Fed is set on a path of rate hikes, and emerging markets will have to manage,” he added. – MarketWatch