Via Email, Albert Edwards at Society General discusses Emerging Markets.

Turkey has discovered that high and rising foreign-denominated debt never sits well with a huge current account deficit and a reluctance to raise interest rates. The problem though is that this is not about Turkey or even EM. It is as always, about the Fed.

When the most important person in the free world starts lobbing macro hand-grenades in an effort to drain the swamp, the financial markets will always eventually react badly. No, I am not talking about President Trump with his tweets about imposing tariffs on Turkey. I am actually talking about Fed Chair Jerome Powell draining the global liquidity swamp.

Make no mistake, whatever the macro-idiosyncrasies of Turkey, the key to the current turmoil that is spreading into EM generally, is Fed tightening and the strong dollar. As we have repeated ad infinitum, since 1950 there have been 13 Fed tightening cycles, 10 of them ended in recession and the others usually saw the EM blow up – such as the 1994 collapse in the Mexican peso. The Fed always tightens until something breaks. It is usually its own economy, but sometimes it is the EM’s. And when the liquidity tide goes out we always find out who is swimming naked. If it hadn’t been Turkey it would eventually have been someone else.

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To be sure the unfolding EM crisis has been building for many years. And just as investors ignored the naysayers in the run-up to the Global Financial Crisis (GFC), they have ignored the IMF and BIS, who have been cautioning for some years about the explosive build-up in EM debt and especially dollar-denominated debt.

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According to the BIS, total dollar-denominated debt outside the U.S. reached $10.7 trillion in the first quarter of 2017, and about a third of this debt is owed by the EM nonfinancial sector. EM specialists, the Institute of International Finance (IIF), have also warned about this build-up in EM foreign-denominated debt. They too note that the EM corporate sector has been leading the explosion of debt, with Turkey standing out for the increase in its exposure since the GFC. Turkey has never managed to escape membership of ‘The Fragile Five’ EM country club.

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Let’s face it: virtually everybody knew this was coming. But in the frantic QE-inspired hunt for yield, no-one cared. And this is always the problem while liquidity is washing through the financial markets because of loose money polices (usually centered around the Fed). Almost no one is interested in heeding the pessimists and positioning of the inevitable financial market blow-up when eventually excessively loose monetary policy is belatedly tightened. Investors, drunk on the elixir of free money, think the good times will roll on forever. And even if they are cautious, a few quarters of underperformance usually invites either capitulation or being fired. With few exceptions, being too early with a bear call is usually a career ending decision. Better to stay in the crowd, remain fully invested and go over the cliff with the herd.


Of course, it is more than just EM that is at risk of blowing up if the Fed keeps tightening (and the ECB and even the BoJ decide to join in). So many financial markets are surfing high on the tsunami of liquidity that has flooded the world over the last decade - this extends to corporate bonds, equities and real estate prices. It is a global ‘everything bubble’.

The key for most commentators on whether the risk dominoes will continue to fall is the Fed tightening cycle. To repeat: 10 of the last 13 Fed tightening cycles have ended in recession. Of course, no-one knows how much tightening will cause a recession this time around, but one thing that the excellent Gerard Minack finds interesting is that the CFTC data shows that speculative investors are eye-wateringly bearish on US government bonds.

Historically the speculative positioning data works well as a contrary indicator, and hence in the absence of a major shock (like a jump higher in wage inflation), we expect US bond yields are more likely to fall from here than rise.

Another Twitter favourite of mine is @LanceRoberts of Real Investment Advice. He wrote an excellent article a couple of weeks back which I meant to highlight about US bond yields banging up against their technical extremes, indicating that yields might be set to fall.

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Lance shows the 10y yield together with a momentum oscillator at extreme highs consistent with decisive cyclical moves down (the top panel). He also shows the RSI demonstrates US 10y yields are extremely stretched to the upside, which also suggest the potential for a strong rally (bottom panel).

Bond Market Signal

Thanks to Lance Roberts and Albert Edwards for these snips.

For further discussion, please see Technically Speaking: Are Bonds Sending A Signal? by Lance Roberts.

Inflation of asset bubbles is mostly in the rear-view mirror. Lower treasury yields are on the horizon. Hedgeye agrees.

Mike "Mish" Shedlock

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