EM FX: strain turns to panic

The emerging market FX world has come under pressure since the election of Donald Trump to the White House. With less than two weeks’ to go before his inauguration, initial signs of strain in the FX space, is now turning to panic for some countries.

Out of 24 EM currencies tracked by Bloomberg, only the Russian Ruble, for obvious reasons, has managed to post a gain vs. the USD since Trump’s election win. In contrast the Turkish lira and Mexican peso are down 16.35% and 15.2%, respectively.

Since the EM FX space does not move as a unilateral block, we have focused on two EM currencies that could steal the limelight in the coming weeks: the Turkish lira and the Czech Koruna.

The lira: embroiled in a political crisis

The sharp decline in the Turkish currency since last summer’s coup has grabbed the headlines, but as we move into a new year, the question has to be how long the authorities’ will allow the decline to continue before it pushes up inflation to unacceptable levels? Prices rose to 8.5% in December, their highest level since the July coup. The continued decline in the lira is in no small part down to President Erdogan’s reaction to the coup, which has seen an extended state of emergency declared and a constitutional referendum set for April, which would expand the powers of the Presidential office. The independence of the central bank has also been called into question, as the President himself has warned against interest rate increases to try and stem the lira decline, instead blaming a conspiracy on the falling value of the TRY.

On Tuesday, the central bank announced some mild measures in an attempt to shore up support for the lira, including a measure to reduce the amount of FX reserves that banks need to hold, along with further measures to reduce Turkey’s corporate FX risk. This has done nothing to boost the TRY, which again fell to a record low versus the USD and EUR on Tuesday. The market wants more than just words before it is willing to buy the lira once more, in fact Tuesday’s move may have actually enhanced the selling pressure on the lira, as it makes it clear that the central bank is under the influence of the government, which is never good from an FX perspective.

Ultimately, we expect the market to win out, and the central bank to embark on more forceful measures such as a large one off interest rate rise, which could cause a sharp reversal in Turkey’s fortunes in the short-term. The risk of a rate hike is growing, especially if we see a series of consecutive sell offs in the TRY this week. Back in 2013 and 2014, Russia’s currency also came under pressure and the central bank embarked on a series of unscheduled rate hikes, eventually pushing interest rates up to more than 14%. While it did not have an immediate effect on the currency, there were periods of recovery in 2015, before the RUB embarked on an impressive rebound last year.
For now, the lira is one of the worst performing currencies in the world as political risks look too great for investors to view the TRY as a bargain. In comparison, the pound’s Brexit premium looks like small cheese.

The Czech Koruna: ditching its peg?

The other currency to watch is the Czech Koruna, which has been capped vs. the EUR at 27 since 2013. This cap is at risk of being disbanded with due to upside pressure on inflation, after Czech prices rose to 2%, the highest level since 2012, last month. The Czech central bank has had to defend its peg aggressively in recent days, as the market tests its resolve to maintain an expensive peg when the Czech economy is doing well. The market is only too aware of the dangers of a disbanded peg, after the Swiss authorities broke their peg with the euro in 2015, causing financial market chaos.

The trouble with pegs, is that central banks don’t always give warnings about when they will come to an end. However, it will be interesting to see if the Czech authorities try to manage themselves out of the peg, something the Swiss authorities failed to do 2 years’ ago. Thus, the first step to getting rid of a peg in a sensible way could be an unscheduled central bank meeting or press conference to inform the public on the Czech authorities’ thinking around the sustainability of the peg.

For now, the spot EUR/CZK rate is stable at 27, however, the derivatives market is where the action is. The 6-month EUR/CZK forward is pricing in a 256 point drop, one of the largest declines since the financial crisis. This suggests that the market believes that there is a very real possibility that the Czech authorities will disband with the peg in the first half of this year.

Due to this, if you trade EUR/CZK, watch out for heightened levels of volatility in the coming days and weeks.