The US dollar suffered terrible losses in July, with the DXY index seeing its worst month in a decade. Positioning remains stretched against many major currencies, with euro longs reaching a record in last week’s CFTC data. Despite this, the dollar remained on the back foot last week, struggling to avoid fresh lows against major currencies before the release of July’s non-farm payrolls report.
The report was better than expected, with a net 1.8m jobs created. The details of the report were encouraging, with job gains broadly distributed across sectors. Permanent job losses ground to a halt after accelerating in June. Employment in leisure and hospitality rose by almost 600,000, despite the recent re-imposition of lockdown measures in these industries across many states. Dollar took no comfort from the report, although US sovereign yields were marginally higher. Attention will now turn to the stalled fiscal stimulus debate in the US. If the report blunts impetus for compromise between Democrats and Republicans, it may yet turn out to be bad news on the whole for the dollar.
Emerging markets were a different story to major currencies last week, with the Turkish Lira suffering severe losses due to concerns about FX reserves levels.
Looking ahead, Turkish authorities are in a difficult position and face the choice of raising interest rates or allowing the currency to depreciate further. This week, various data releases will be of note for financial markets, while developments in US fiscal policy and US-China relations will also remain in focus.
► Monday 10/08:
A fairly quiet day with Japan observing the Mountain Day holiday. Sentix investor confidence figures from the Eurozone will be out at 09:30 BST. July’s survey was the third consecutive monthly increase in the index, although the -18 reading still pointed to a sustained economic contraction. Usual caveats about diffusion indices apply and the release is probably best treated as a simply sentiment gauge. The NIESR’s GDP estimate for the UK will be released, as will the Job Openings and Labour Turnover Summary in the US at 15:00.
► Tuesday 11/08:
UK labour market data will be released at 07:00 BST. The Labour Force Survey counts as employed people who are temporarily not working and receiving no pay, as well as furloughed workers. As such, it is a not a complete measure of the true rate of inactivity and joblessness in the economy. Experimental weekly data showed that total hours worked were 25% below their pre-covid levels in April, before improving in May. The continuation – or stalling – of this improvement may be a helpful read of the state of the labour market, as will jobless claims. The ZEW survey will be released for the Eurozone and Germany at 10:00. The ZEW survey will be released for the Eurozone and Germany at 10:00. The headline ZEW expectations index is expected to fall for the first time since March, from 59.3 in July to 54.0, according to forecasts submitted to Bloomberg. The assessment of the current situation is expected to have risen to -70.0 from July’s -80.9. Parts of Spain went back into lockdown last week, and with countries all throughout the continent noticing an uptick in virus cases, the prospects of a second wave may begin to weigh on sentiment. Several eurozone countries have been quick in enacting additional localised containment measures, such as mandatory tests for travellers from high-risk countries.
► Wednesday 12/08:
The RBNZ releases its latest rate decision and monetary policy statement at 03:00 BST, followed by a press conference at 4:00. June saw the RBNZ leave all policy settings unchanged, and since then data has generally suggested the NZ economy has maintained a strong recovery, helped along by the most favorable domestic covid-19 situation of any developed economy. Hours worked in Q2 fell by only 10%, an enviable trough compared to peer economies. The threat of a second wave of covid infections is also greatly smaller in NZ than elsewhere, due to a lack of community transmission. The RBNZ is therefore likely to remain dovish, but cautiously optimistic. Two issues will be interesting for NZD: firstly, the RBNZ’s own attitude to the currency, which has appreciated with the rest of the G10 and may present a mild drag at the margin for the economy. Secondly, the RBNZ’s attitude to negative interest rates will be of interest. The policy statement and press conference will be an opportunity to judge if policymakers view the option as a last resort for a flagging recovery, like the Bank of England, or are more receptive. Some research suggests, as the BoE concluded, negative rates are most effective during the upswing phase of a recovery when banks are less concerned about their balance sheets. Depending on the RBNZ’s assessment, this may make NZ an early adopter of the measure during this cycle, should the recovery flag.
Later on Wednesday morning, preliminary UK GDP for the second quarter will be released at 07:00, alongside various subsidiary indices for trade, services, production and investment. Various high-frequency data suggest that the trough for gross domestic product in the second quarter may have not been as low as previously feared, and the recovery since then has been better than expected. Consumer spending and the property market are two areas of optimism for the BoE. The Bank of England expects a 20% cumulative decline in GDP over the first half of the year, meaning that the Q2 figure will still be hair-raisingly high. The median of the 8 forecasts submitted to Bloomberg is for -21.3% quarter-on-quarter growth.
At 12:00 BST, South African retail sales data is released for June. Expectations are for an 11.9% MoM rise in retail sales, but with the economy returning to stricter lockdown measures in July, this may be the last positive reading for some time. US CPI inflation at 13:30 BST will be the next major release, with the Federal budget balance due later in the day.
► Thursday 13/08:
Banxico will release its latest policy decision, discussed in detail below.
► Friday 14/08:
China will release retail sales data for July at 03:00 BST. The Chinese economy has been on a manufacturing fueled recovery, but consumer spending continues to lag. High frequency data shows Chinese consumers remain cautious to return to pre-virus consumption patterns, which will be evident in July’s release. A 0.1% YoY reading is expected, which would mark the first positive month of growth in retail sales since the outbreak back in Q1.
Although Eurozone flash GDP is released in the morning, the release already lags much key hard data and its impact is likely to be muted. US retail sales for July at 13:30 BST dominate the day’s calendar. A variety of alternative data suggest that the re-imposition of restrictions on some bars, hospitality, and indoor entertainment across 10 states in June and July caused a slowing in consumer spending. The official release will show just how reliable these alternative data are, and provide arguably one of the stronger reads on the health of the US consumer.
Chart: Alternative data suggests flattening in US consumer spending growth in July
What’s next for the lira after it hit a record low and reserves ran dry?
Last week saw the Turkish lira carve fresh all-time lows against the dollar, with the surprise being its timing as opposed to the event itself. The lira started off this week relatively stable, just below the psychological 7.00 level as Turkish markets enjoyed a public holiday on the Monday. However, upon the market’s return on Tuesday, sparse offshore liquidity caused the overnight implied yield to skyrocket above 1000% in annualised terms, sparking concerns that capital controls were being re-imposed. However, it seemed to be more due to a lack of liquidity in offshore markets as opposed to a new undeclared policy by officials. This was evident by the overnight rate quickly normalising on Wednesday. However, with the normalisation came fresh selling pressure on the lira, which found itself breaking the 7.00 level that evening. The breach of the psychological level came despite reports that Turkish state banks sold more than $1bn to try and stem the effects of heightened demand for foreign currency that day. The lira continued to slide for the remainder of the week, hitting fresh all-time lows both Thursday and Friday. In response, Turkish officials vowed to use all measures to curb excessive volatility in the currency, but this was an ambiguous statement with little clarity for markets.
Was it a declaration of potentially higher rates by the TCMB in the coming weeks? Or perhaps a further reduction in offshore liquidity conditions to prevent further currency depreciation? Or will the Erdogan administration give up the ghost and let the 7.00 level slide?
In our opinion, it is likely to be a mixture of all of the above, with an interest rate hike potentially needed before the next scheduled meeting on August 20th. We see interest rates being hiked 100bps at the central banks next meeting.
Chart: Turkey’s central bank reserves run dry as the defence of the lira dwindles, reserves left are propped up by domestic swap lines. (Note: all FX data is as of July 31st with the exception of LATAM countries where data is as of June)
How did it get to this point?
Prior to the outbreak of the global pandemic, the TCMB had been on a rapid easing cycle after hiking the repo rate to 24% in the aftermath of the 2018 currency crisis. The disinflationary channel created by the effects of a more stable lira and higher interest rates gave the central bank the space to lower rates aggressively, with the repo rate cut by 1575bps in little under 12-months. In markets, to deter short sellers, foreign investors practically lost access to borrowing from local banks, forcing them to borrow liras in the offshore market where liquidity is thin. This, along with brief periods of market distortions leading to higher hedging costs, crippled foreign investor sentiment as the risks to hedging exposure were too high and subject to dramatic swings in offshore liquidity. This system suited Turkey’s economy while maintaining political approval, although foreign investment was in a state of tatters.
Chart: Foreign investment failed to recover in Turkish assets after TRY crisis in 2018
Then the pandemic hit. Emerging markets experienced capital outflows reminiscent of the 2008/09 financial crisis and the Turkish lira quickly reached a fresh low of 7.269 against the dollar. Intervening in markets, the efforts by State banks quickly brought the lira back below the 7.00 level and the new implicit managed float style system all but killed volatility in the USDTRY cross. While authorities were quick to dispel any suggestion of capital controls in Turkey’s markets, the extreme intervention in FX markets along with the prolonged liquidity shortage in offshore markets suggests otherwise. The liquidity shortages in offshore markets led to multiple spikes in implied rates used for hedging options, which resulted in widespread settlement failures. This led to major banks such as Citi, UBS and BNP Paribas being banned from accessing local lenders, which meant further restrictions to Turkey’s capital markets for foreign investors. In response to the viral outbreak, cheap credit was issued in Turkey. Domestic loan growth rose to levels not seen since 2018, resulting in a deterioration in the current account and further pressure on the lira.
Additionally, the TCMB’s easing cycle ground to a halt, with the central bank cutting 250bps since March but holding rates at 8.25% at the last two meetings in June and July. Real rates remain in negative territory, which isn’t helping the trajectory of inflation, especially now a weaker lira is in play.
Chart: credit expansion led to Turkey’s current account returning to a deficit, putting pressure on the lira.
With negative real rates and cheap credit resulting in a current account deficit re-emerging, Turkish monetary policy was walking a fine line while still defending its politically sensitive currency. Reserves began to drain as if the market had just pulled the plug on the lira. Foreign currency reserves fell by $34.6bn despite strong domestic debt issuance, while Goldman Sachs estimates that year-to-date interventions come in around $65bn. This highlights the length to which monetary authorities buffered market forces.
With reserves rapidly depleting, credit growth still elevated but set to taper according to recent central bank communications, and the tourism industry in a state of tatters, it is arguably the time for the lira to weaken above the 7.00 level in the medium-term and higher interest rates.
What’s next for the lira?
This is where things get tricky. The political consequences of both a higher interest rate and a weaker currency are severe for President Erdogan. After losing a large share of his base in last year’s election, notably in key metropolitan hubs such as Istanbul, the President will be keen to control the latest events in the most limited way possible. Reserves have basically hit rock bottom, with the current data being propped up by swap agreements with local banks as some $200m of household wealth is held in foreign currency in Turkey. So this leaves Turkey with three options, all of which have negative consequences for the economy.
► Option 1:
Continue to drain offshore liquidity to stabilise the currency. We see this as the likeliest near-term solution in order to prevent increasing short-positions building up. Despite the overnight rate returning from 1000% to normal levels of around 6%, hedging costs further out remain elevated. For example, on Friday of last week, the implied yield on 1-week and 3-month forwards was 28.245% and 22.15% respectively. This isn’t just driven by liquidity measures, but also expectations of rising interest rates. However, as seen in the aftermath of 2018, this cripples foreign investor sentiment, which will ultimately cap the longer-term recovery of the lira once economic conditions stabilise.
► Option 2:
Let the lira continue to slide while maintaining limited access for capital markets. With the treasure chest of reserves practically empty after discounting the impact of swap lines with domestic banks, Turkish officials could hold the interest rate at 8.25% and allow the lira to depreciate and clear the pressure from the current account deficit as the credit stimulus winds down. While this could limit the likelihood of higher interest rates and lower growth, it exposes one of Turkey’s largest financial vulnerabilities. A substantial share of corporate debt is issued in foreign currency, about $289bn to be exact, while $169.5bn of Eurobonds are to be rolled over in the next 12-months. A weaker currency would not only increase the cost of servicing, but also refinancing debt.
► Option 3:
Higher interest rates. While this option prolongs the economic recovery and could further erode Erdogan’s popularity, it is arguably the most effective means of controlling the slide in the currency. Raising rates in line with the expected inflation uptick to keep real rates neutral is a likely option. However, given the political opposition to higher interest rates we expect Turkey’s real rate to remain negative this year unless conditions deteriorate substantially. Governor Uysal must tread this path carefully though as such a route eventually led to the demise of his predecessor, Murat Cetinkaya, back in July 2019.
The drawbacks of all of the options above means a blended response is the likeliest option from Turkish officials.
We see the cost of taking short positions in the lira rising initially as offshore liquidity thins even further, while a continued depreciation in the lira takes place.
All the while, credit stimulus will be wound down. If conditions allow, interest rates will remain on hold until the TCMB’s next meeting on August 20th, however risks are tilted towards an earlier announcement. We expect the central bank to front-load their monetary tightening to restore confidence in markets with a rate hike of around 100bps this month.
Another prudent rate cut by Banxico won’t clear the path ahead as soon as next week
The Central Bank of Mexico is scheduled to make its next monetary policy decision on August 13th. The bank is widely expected to slash another 50 basis points from the policy rate, which currently sits at 5%. This move will come on top of the 200bp already cut since the beginning of the pandemic crisis in March and the 325bp cut overall along the current easing cycle, which started a year ago. Consensus forecasts among analysts and financial institutions suggest that Banxico is likely to park the policy rate at 4.50%, around the estimated level of policy neutrality.
This is a prudent stance, at which Banxico will be injecting stimulus into the economy while also avoiding undesired inflationary risks. As Banxico´s forward guidance has been markedly vague, all eyes will be on any hints about the central bank’s next steps beyond the likely rate cut next week.
Money markets have already adjusted their policy expectations and pricing seems to indicate expectations of additional monetary stimulus over the course of the year ahead, to a terminal rate of 4% before the normalization path begins in two years time. This is probably a natural reaction to the bleak economic outlook facing the country amid the recessionary risks presented by the pandemic. In Q2, the Mexican economy plummeted by a record 17% on a quarterly basis, as containment measures weighed heavily on private consumption and economic uncertainty expanded the 16-month long investment contraction. The fall in external demand, especially from the US, has weighed on exports, while growth in public spending remains subdued in the face of a stubbornly rigid fiscal policy. The concerning pandemic situation in Mexico and US border states complicates any prospects of sharp economic resumption, with median estimates of a 10% GDP drop in 2020.
Banxico does have additional room to using its current policy tools, especially under the prospects of a flatter US yield curve. At 4.50%, Banxico´s position relative to other central banks in emerging markets is still conservative, even compared to its own historical low of 3% in 2014-2016. However, there are strong reasons preventing Banxico from going far beyond this level.
Effectiveness, on one hand, remains in question. In the current institutional environment -insufficient access to the banking system and high levels of informality- the ability of monetary policy to boost the economy is limited. The spread between Banxico´s policy rate and the interbank cost of liquidity is currently at the narrowest level since 2016, indicating that credit supply might be overstepping the market´s intake capacity. As a trade-off, lower interest rates could also trigger a risky capital outflow and currency depreciation, which would dampen the Mexican debt profile and curtail already weak growth prospects. Finally, Banxico´s hands will likely remain tied to increasingly balanced risks to the inflation outlook, which was previously tilted to the downside.
Chart: Loose credit conditions in the interbank market leaves little else to do to the Central Bank
For those trying to guess Banxico´s forward guidance, the policy meeting next week could prove disappointing. Under relatively stable financial market conditions and broad uncertainty in the persistence of inflation trends, Banxico could choose to wait until September´s Fed meeting to provide further clarity on its next steps.
At 4.50%, Mexico still holds one of the highest nominal and real interest rates in the world. This could continue to support the attractive carry embedded in the Mexican peso, which has kept trading range-bound amid a weakening EM currency basket.
However, as Banxico approaches its tolerance level, monetary policy may retreat as a major currency driver, while upcoming US general elections dominate MXN price action. Hedging costs against USDMXN volatility remains well above pre-coronavirus levels and have started to rise again after falling from March´s multi-year highs.
Chart: Hedging against MXN volatility is turning expensive on the back of upcoming US elections.
Ranko Berich, Head of Market Analysis
Simon Harvey, FX Market Analyst
Olivia Alvarez Mendez, FX Market Analyst
Ima Sammani, Junior FX Market Analyst