The Wolf met with a very well respected team of London-based emerging market debt/currency managers in New York on Thursday who confirmed our suspicions about trouble ahead for emerging market currencies. At Trader Skillset, we use technical analysis above all else to determine Context, but sometimes understanding fundamentals can clarify and strengthen a previously held opinion*. According to The Wolf’s contacts, Turkey’s quantitative risk assessment of a currency/debt crisis is the highest in the world (of tradable markets), at levels where prior crises have occurred.
Here’s some background. The Central Bank of the Republic of Turkey recorded its lowest interest rate ever in May of 2013 at 4.25%. But, cracks in the low interest rate policy developed in earnest as the lira started to weaken dramatically that summer – it lost 30% of its value in six months. In January of this year, the central bank hiked interest rates 5.75% in one move in order to defend the currency and quash inflation. But, according to our charts, and our contacts, more lira selling is directly ahead, while geopolitical and fundamental problems may actually lead to a currency or debt crisis similar to that of 1994. And, based on our charts of other emerging market currencies, and other weak debt (see last week’s JNK piece), it likely will not be contained.
Turkey has been in the midst of geopolitical conflict for thousands of years, partly due to its size and geographic location. That’s all to true today with the Kurds, ISIS and Syria all adding complexity to Turkish politics, monetary policy and the potential for economic activity to stall. With last quarter’s GDP showing contraction, official inflation rates north of 8% and a current account deficit/GDP above 8% the central bank is in a quagmire. It wants to “support growth” with lower rates, but in order to attract capital and keep inflation low it’ll need to hike rates. If it hikes rates we could see a collapse of economic activity and tax revenue, which would pressure the bond market.
Here’s the technical picture for USD/TRY, which is the alternate count from our previous review of the Exotics. Prices found support at the channel line, and the previous fourth wave in May and again in July. The action since wasn’t initially clearly impulsive to the upside, but with the upside push of the last several weeks, and very little retracement, it shows the hallmark of an impulse. This week saw a decline into support, and the Wolf tweeted our bullish posture after Thursday’s reversal (Please follow us for real-time updates @TraderSkillset.). In addition, notice how the wave ((3)) peak was seen with a new high on RSI. This convergence means that we’ll likely see a push above 2.40 at a minimum. We’re not showing a daily chart, because sometimes it’s more important to remain focused on the longer term trend. This is a buy the dips market, and we don’t need to worry about counting every single wave because we think it can go much, much higher.
Here too, new highs are likely to be seen. We may have hit the wave 3 peak, but even so, support should come in at, or just below, this week’s low. We’re bullish here too. As a side note, our London PM contacts believe that a crisis will not develop in South Africa, and that a sell off is a buy for ZAR and its bonds. Our count suggests there’s plenty of room to the upside first (downside for ZAR), however.
The peso also looks quite vulnerable versus the US dollar. Here prices are still below near term resistance, but the action down from the wave ((3)) high looks corrective, so there’s also plenty of upside. Notice how prices went back down this week to attempt to retest the broken down trendline. The reversal late in the week, with the close near the high, means another emerging market is likely to come under pressure. Is it a coincidence that both Mexico and Turkey had crises in 1994?
While our London contact thinks the crisis in Turkey will be contained, and he happens to like the underlying fundamentals in Mexico and South Africa, our charts suggest otherwise. In fact, our charts point to the potential of another “’97 Asian Contagion” style emerging market collapse. During that crisis, the tiny Thai baht collapsed followed by a total repatriation of capital out of EMs. It’s not important for Trader Skillset to forecast a crisis, but what we do want to emphasize is that traders should let positions run as much as possible in this environment given the potential for things to get out of hand.
* An example of how understanding fundamentals can confirm positions, and allow for additional follow through, would be the 2007-09 credit crisis. Once we understood the amount of leverage that existed on the financials’ balance sheets, we were comfortable pressing shorts of homebuilders and financials even when they were down 60-70%. In fact, because they had already fallen that much, it implied that many of the equities were at risk of bankruptcy (MER, LEH, WM, FNM, C, etc.).
The time zone we reference on our charts is Pacific Standard Time. Therefore, the U.S. cash market opens at 6:30 AM PST and closes at 1:00 PM PST.