How much of emerging market turmoil is a strong dollar story?

Quick note on the daily: Today’s daily post will be delayed but will come out later today. I am writing this more investment-themed post on currencies first and opening it up to all patrons to give you a heads up about the delay and my coming schedule. Next week, I will be on holiday (woo-hoo)! And I don’t intend to write. I may write the odd post here and there though. But, regular posting won’t resume until the following Monday, August 27th.

Temporary relief for emerging markets

As for today, a couple of developments have lent support to emerging market currencies. First, Qatar pledged to invest $15 billion in Turkey after Turkey’s President Recep Tayyip Erdogan and Qatari emir Sheikh Tamim bin Hamad al-Thani lunched in Ankara together. That’s not a huge amount given the size of Turkey’s foreign-currency debt. But it was enough to relieve some pressure from emerging markets.

Also, trade talks between China and the US are set to resume in Washington later this month, Chinese officials in Beijing said this morning. That gives the markets some hope that the US and China can avoid a destructive trade war.

Even so, the PBoC did fix the yuan lower today after the offshore yuan fell nearly 0.8% to 6.9467 per dollar. That’s the weakest level since January 2017. And it is dangerously close to the psychologically significant 7 yuan per dollar level we haven’t seen since the depths of the financial crisis in 2008.

Strong dollar is bad for EM

I am looking at this as fundamentally strong dollar-driven. For example, early in European trading hours, the index that tracks the dollar against six major currencies hitting 96.984, the highest since June 2017. The euro fell to $1.13010, the lowest in 13 months. The British pound sterling reached a 13-1/2 month low versus the dollar too. And that’s despite UK government data showing inflation picking up in July for the first time this year.

So this isn’t just about Turkey. It’s not even just about contagion to emerging markets from Turkey or concern about slowing growth in China. What we are seeing is what happens when the US central bank begins a rate hike cycle before the other central banks. And we are seeing what happens when the Fed has a tightening bias, accelerating its rate hike timetable.

That’s particularly bad for emerging markets. It always has been. Emerging market crisis in the early 1980s and late 1990s were both due to Fed tightening cycles. This is why we are seeing an unusually large impact on emerging market currencies and on emerging market equities.

Before the relief rally today, the MSCI’s emerging market currency index hit its lowest level since July 2017 on Wednesday. And the 24-country MSCI emerging market index for equities officially hit bear market territory yesterday, losing 20 percent since January.

Turkey is not the trigger for a full-blown crisis yet

And while I think EM is more resilient than it was in the 1980s or 1990s, it is also larger. More than $1.9 trillion of global assets are benchmarked to the MSCI EM index. We’re talking about a broad range of companies and countries since the index includes 830 stocks, with China making up only 33% and India, Brazil and Russia accounting for 9%, 6% and 4% respectively – or roughly half of the index.

Having said that, I don’t think Turkey is going to trigger a full-scale global panic. This is not like Long Term Capital Management’s near-collapse in 1998 after the Russian default. If anything it is more akin to Thailand from the 1997 Asian Crisis.

And that’s what has emerging market investors concerned. We are early in any potential chain of events — which may or may not have serious ramifications for developed markets. But it is already having a big impact on emerging markets and the parallels to 1997 are definitely there.

For now, the key is not Turkey. And it’s not just the withdrawal of dollar liquidity as the Fed tightens. It’s the sensitivity of central banks in Japan and Europe to what’s happening. Right now, only the Fed and the Bank of Canada are actively tightening. If other central banks join in as well, it will worsen the crisis in emerging markets considerably as foreign-currency debts come due.

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