The next emerging markets crisis is now: Turkey as a canary in the coalmine

Note: This post was originally published on Patreon on 11 Jul 2018

Turkish bond yields are skyrocketing as the Turkish lira plummets today. This is all because of signs of poor governance to add to the existing signs of poor macro fundamentals. The question, though, is whether Turkey is an outlier or a sign of more to come.

A personal tale of Turkey’s descent into authoritarianism

During the European sovereign debt crisis, before he was Deputy Prime Minister, Mehmet Şimşek and I followed each other on Twitter. He’s a guy of Kurdish origin who went to a British University and worked in the City of London and on Wall Street for international investment banks back when I was there too. He only entered politics in 2007.

When he joined Erdogan’s cabinet as Finance Minister in 2009, it was seen as a good sign. Erdogan had a trusted pair of hands controlling Turkey’s finance ministry that gave the country credibility when crisis hit, as in 2014 after the Taper Tantrum.

Şimşek continued to follow my Twitter account through all of the state Twitter bans in Turkey. His Twitter activity changed though and he became much more circumspect about his activities on social media, toeing the line on economic policy statements. At some point following the failed coup d’état in 2016, he stopped following me and a host of other western finance accounts on Twitter. And I knew straight away that this was a bad sign.

Fast forward two years and he is no longer Finance Minister. After the recent elections in Turkey, Erdogan’s son in law Berat Albayrak replaced Şimşek. And while Albayrak is also a more western-friendly business figure, the fact that he is Erdogan’s son-in-law is the most important part of his CV. His appointment is a bad sign.

The market reaction

So it’s no surprise that the Turkish lira is in freefall. This morning, news came out that the Turkish current account deficit for May was $5.85 billion vs an expected $5.45 billion and $5.51 billion in April. The deficit for the past 12 months is now $57.6 billion. That’s about $10 billion more than the 2017 figure.

On the news, the Turkish lira was down this morning to 4.7160 from under 3.0000 around the time of the failed coup d’état. That makes the current account deficit likely to grow larger. And it forces Turkey to either raise rates to try and stabilize its currency or face an out-and-out currency crisis. Right now 10-year Turkish yields are over 17%, up from below 9% right before the coup d’état in 2016. They will likely go higher still.

The next emerging markets crisis is now

I see Turkey as a country in crisis. And likely, this crisis will get worse as the governance issues add to the poor macro fundamentals. The Şimşek-Albayrak trade is a signpost of this. But, as with Greece and the European sovereign debt crisis, the question is whether Turkey is unique. The answer with Greece was yes and no. Yes, Greece was unique in the severity of its problems. No, Greece was not unique as other European countries required bailouts to right the ship.

I expect the same here again. Now part of the problem is the Fed. The US central bank thinks the US fundamentals are good enough to warrant more rate hikes this year. The chances of a September hike are now looked at as 84% by the market. Even Chicago Fed President Charles Evans, once considered a dove, is ready for one or even two more hikes this year. Today’s Wall Street Journal captures the mood at the Fed:

“The economy seems so strong it seems natural that businesses and consumers can live with” slightly higher interest rates, he said, citing the effects of the fiscal measures approved by Congress and the White House.

“Whether or not you think we should [raise rates] three times in 2018 or four times in 2018, it’s really not going to make a big difference,” he said.

That is going to make life hard for the emerging markets. And with Turkey already in trouble, expect other emerging market countries to follow suit as their currencies drop, yields rise and growth falls. Argentina has already been tested with Turkey. Other countries with poor fundamentals include Malaysia and Ukraine.

But other countries will be tested. And despite the large horde of foreign reserves, these may not prove enough to arrest the fall of EM currencies unless these countries raise rates as well as intervene in currency markets.

In short, we are on the verge of another emerging market crisis. What this means for developed economies is still to be determined.

My take: Watch the Treasury futures market for where developed economy fortunes are headed. They are sending a signal that the 2-year/10-year spread will be 15 basis points by year-end. I expect the spread to be tighter still.

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