Emerging Market FX: The Straw That Broke The Carry-Trade's Back

FX markets featured significant volatility in the past week, though the driver of that volatility was a combination of several idiosyncratic factors, rather than a core underlying narrative.  Widespread risk aversion and position unwinds dominated market trading with China PMI, weak US earnings, and BoJ un-dovishness cited among more systemic factors. Turkey and Argentina (among others) have more idiosyncratic risks (and limits approaching) but as Barclays notes, market positioning has played a major role in the moves as market volatility appears to have been the straw that broke the carry-trade’s back – for now… as EM currency returns have notably decoupled from moves in US rates.

Barclays on carry-US rates dislocation

FX markets featured significant volatility in the past week, though the driver of that volatility was a combination of several idiosyncratic factors, rather than a core underlying narrative.  Widespread risk aversion and position unwinds dominated market trading on Friday. An initial catalyst was the HSBC Flash China manufacturing PMI, which declined to 49.6 (50.3 consensus), an indication of continued slow growth momentum, according to our economists. Less-than-stellar US earnings releases were also likely contributed  a broad-based risk reduction.   

On a cross-sectional basis, weekly FX returns were negatively related to FX carry, and in that sense, the moves were similar to the risk aversion that swept markets last summer. However, adjustments of term premia in US rates were not the explanation, as higher-carry currencies came under  pressure in the context of a bull flattening in US rates. More generally, emerging market currency returns have decoupled from moves in US rates.

Although US rates volatility has fallen since November, Barclays index of emerging market currencies has set record lows. In our view, this is indicative of clear idiosyncratic risks developing inside some emerging markets. It is not surprising that, in the context of the political and monetary developments in the respective countries,  TRY and ZAR underperformed relative to peers, when controlling for carry.

Market positioning also likely played a role in the volatile price action. For some currencies, positioning has become slightly stretched, particularly in the JPY (Figure 3). In a context of market liquidation of the magnitude we witnessed on Friday, it is logical that some of the previously strong performing trades (short JPY and long GBP (Figure 4)) were unwound.

Developments in Turkey were a prominent idiosyncratic driver last week, with TRY a standout underperformer. The Central Bank of Turkey (CBT) intervened directly in the FX market on Thursday, selling about USD3.0bn.  We note that, given the relatively low levels of CBT’s reserves, room for additional intervention is quite limited. We think testing the market by running down net FX reserves further could be a risky path.  Therefore, we continue to believe that the CBT may ultimately have to use interest rates to defend the TRY

Barclays – Assessing The Turkish Central Bank’s FX intervention strategy

The Central Bank of Turkey (CBT) intervened directly in the FX market this week, selling about USD3.0bn according to Bloomberg. This is the largest direct FX intervention in a single  day and the CBT’s first direct intervention in the FX market since 2012, when it sold about USD2.9bn between 30 December 2011 and 4 January 2012. This week’s direct intervention appeared to be triggered by USD/TRY rising above 2.29, which suggests that the 2.30 level or above (which translates into REER at 97 or below) seems to be the CBT’s “pain threshold”, in our view. The CBT has spent about USD5bn of its reserves since the beginning of the year, including its daily interventions in the FX market, which total about USD2bn. This leaves gross reserves at USD106bn, and net reserves at USD37bn following the intervention, and it raises the questions about the adequacy of the CBT’s remaining reserves and how much room the CBT has for FX interventions. The wide gap between gross reserves and net reserves can be largely explained by domestic banks’ FX deposits at the central bank. These deposits consist of reserve requirements for FX liabilities, and the FX deposited as a replacement for TL to meet TL reserve requirements under the reserve option mechanism.

 

In principle, the CBT could use all of its gross reserves for intervention, including those against which it has liabilities (eg, banks’ FX deposits). However, even if this were technically possible, spending more than its net reserves (ie, running a negative net FX positions) could generate a significant loss of confidence. Given that Turkish banks borrowed a sizeable amount of FX from international markets that they then deposited at the CBT, the idea that the CBT is spending these banks’ FX could significantly dent confidence in the system. We think the CBT is well aware of this. Hence, effectively the CBT can use only its net reserves to intervene. Given how relatively low its reserves already are (see Figure 1), we think the room for additional intervention is quite limited. It is impossible to say whether the threshold would be USD30bn, USD25bn or USD20bn, but past experience with falling reserves suggests that the related confidence effects are not linear. Therefore, testing the market by running down its net FX reserves further could be a risky path.

 

Therefore, we continue to believe that the CBT may ultimately have to use interest rates to defend the TRY. At the January MPC, the CBT refrained from delivering a rate hike but instead introduced a new “virtual” rate of 9.0%, which replaces the overnight lending rate (7.75%) during additional monetary tightening days (AMT). The CBT has stated that Monday will be the additional monetary tightening day (AMT), and we now believe the CBT will declare more frequent and longer additional monetary tightening days to push money market rates and the effective cost of CBT funding higher. The next question is, however, even if CBT pushes the interbank money market rates to 9.0%, will it be enough. After remaining behind curve on several occasions, at some point the CBT may need to surprise the market on the upside to gain credibility, in our view.

Half way around the world, Argentina is making more headlines following its devaluation by the ‘easing of currency controls’ aimed at stemming the panic demand for USDollars is a “measure in the right direction,” according to one local bank CEO. As Bloomberg reports,

Andre Esteves, chief executive officer of Sao Paulo-based investment bank Grupo BTG Pactual, said in an interview on Bloomberg Television. “Who’s pushing this devaluation isn’t the financial market, it isn’t speculators, it isn’t derivatives. It’s basically the society of Argentina.”

 

As one trader noted, with regard the currency control easing – “Markets will give them a day or two,” Morden said. “But if there’s no follow-up, the prices trade lower again.”

The new rules, simply put allow

Argentines will be able to buy dollars in proportion to their income, and a 35 percent redeemable tax on buying foreign currency will be cut to 20 percent, he said. Currently, Argentines are often denied requests to buy dollars from the central bank, fueling illegal street trading in which the peso has changed hands at as little as half the value. Policy makers are trying to close the gap between the two exchange rates.

The IMF remains happy – but we can’t help but read the following desription of Fernandez’s policies and think about the US…

Fernandez’s policies of printing money to fund social spending on subsidies while freezing utility rates amid accelerating inflation are unraveling as the budget deficit widens and funding from the treasury and pension fund grows.

Of course, they are running out of time – as we noted Friday –

Reserves have tumbled at a rate of $1.1 billion a month over the past year to $29.3 billion, the lowest since November 2006. They’ve declined 44 percent from a record $52.6 billion in 2011.

However, traders now have a bogey to aim for…

Cabinet Chief Jorge Capitanich will explain the process to buy dollars tomorrow

 

Govt sees 8 pesos/USD after last wk’s devaluation as acceptable level

 

Govt won’t allow peso to fall to 13/USD, which would have devastating effect on production, employment and salaries

So all those wannabe Soroses… 13 is the line in the sand…

    



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