These Two "Emerging Market Canaries" Just Fell Over

Over the weekend, we showed why according to Macquarie strategist Viktor Shvets, the "biggest risk facing investors over the next 12 months" was an intense appreciation in the US dollar. The key reason behind the thesis was simple: a sharp reduction in dollar supply has been observed as the Fed destroys liquidity by shrinking its balance sheet resulting in a contracting US monetary base, coupled with the seeming inability of the US to significantly widen its CA deficits (despite public sector dis-saving).

This was shown in the chart below:

Now, in a strategy note sent to us  by Neels Heyneke and Mehul Daya of South Africa's Nedbank, the analysts reach the same conclusion as Shvets, claiming that we are now entering "the beginning of a prolonged risk-off phase as global dollar liquidity has started losing momentum."

Just like for Macquarie, Nedbank agrees that "it's all about the dollar", explaining that there is nothing more important than "getting the dollar right." Here's why:

The US dollar is still the dominant global currency, and a stronger dollar is an indication of tighter global financial conditions.

If this is the case now again, and we believe it is, then we can expect real rates (term/risk premium) to rise, which would be negative for risk assets. The tighter financial conditions would also be deflationary by nature.

We therefore expect the US10yr to rally (continuation of the 30yr bull trend), reflecting the deflationary forces of a stronger dollar and contraction in the Global $-Lliquidity – this would not bode well for risk-assets (like SA bonds/FX /equities).

One can see why Nedbank is concerned with its version of a chart we first presented three months ago:

Meanwhile, once again echoing Macquarie, Nedbank then points out that its own global $-Liquidity indicator has been losing momentum "due to the tightening monetary conditions by the US Federal reserve (and as US current deficit shrinks)", the same reasons highlighted by Shvets previously, and largely repeating the same warning as we noted before, Heyneke writes that as "dollar liquidity slows down, it is likely to unwind the extreme positioning and enforce a strong dollar (ie de-risking)."

To be sure, if indeed a significant dollar repricing is in the works, the first place one would see the turmoil - is the same place we already have seen turmoil in response to the recent spike in the dollar: emerging markets.

A contraction in Global $-Liquidity, as reflected by a stronger dollar and tighter financial conditions, is likely to correct the distortion between deteriorating EM fundamentals and the carrytrade (portfolio allocation to EM).

And while we pointed out last week that EM had just suffered the biggest outflows since December 2016...

... should dollar strength continue, that would be just the beginning of a sharp rotation in capital away from EMs.

Ok fine... but we knew all of this already; where the Nedbank report differs from Macquarie, however, is that it lays out what its authors believe may be a trigger point, or rather "canaries in the coalmine" to determine just when the Emerging Markets inflection point hits.

As Heyneke writes, there are many "canaries" that are starting to "fall over", which is why the strategist is "deeply concerned about current market conditions. We are faced with very large risk-on positions (ie record net long positions in oil, copper, EUR/USD etc)."

The first "canary" is that the Bloomberg EM FX carry index has finally broken out of the bull trend first launched in early 2016 with the Shanghai Accord. Here's Nedbank:

The carry index is an important “canary” to monitor. The index has broken out of the bull trend at 260 and has rallied from the 255 neckline on Friday to test 260 from below.

The next few days will be important, as a consolidation below 260 would confirm a major reversal.

A break below the neckline at 255 and below the wave-A high at 252 would project substantial downside (to below the (red) wave-C low of early 2016). The MACD has also confirmed the break out of the bull trend.

The second "canary" is even more ominous, as it is not merely some squiggle on a chart but a direct market response to funding conditions, and suggests that a dollar shortage is already spreading among Emerging Markets.

As Nedbank shows in the chart below, the Bloomberg Barclays EM local and USD denominated debt spreads "has taken out the highs of 2016 and has broken into the late-2016 lows", suggesting that EM funding conditions are now reminiscent to the days when every single night Chinese stocks would crash as traders panicked over China's ongoing devaluation.

Here, Heyneke warns that the latest move sharply higher in yields "is likely to be more than just a correction phase and should target the neckline at 5.50%" for one reason:

The world, and in particular emerging markets, has been on a dollar debt binge – one that has issued over $ (rest of world $10tn) in dollar debt. Hence our concern that a slowdown in dollar liquidity would not bode well for dollar-indebted nations/corporations.

Putting it together, Nedbank concludes that "if the EM currencies fail over the next few days to break back into the bull trend that has been in place since the start of 2016", or in other words, if the Dollar move higher continues, "then it is just a matter of time in our opinion before the EM currencies force foreign investors out of the EM markets."

That, incidentally, is also part of what Macquarie dubbed the "biggest danger facing investors over the next twelve months."


ted41776 Mon, 05/14/2018 - 14:00 Permalink

what? there's something wrong with an economic model based on industrializing (putting in perpetual debt) all of the world's countries? but why? perpetual debt is where it's at and when every person on the planet is buried up to their ears in debt, just create more debt against their unborn grandchildren. what could possibly go wrong? surely it would just continue forever and ever. now get on with it, there's freedom and democracy to be spread

Hikikomori Mon, 05/14/2018 - 14:00 Permalink

Canaries in a coal mine are there to detect carbon monoxide.  The faster the metabolic rate, the quicker a being succumbs to carbon monoxide, and canaries have a far faster metabolic rate than humans.  With carbon monoxide poisoning, first you feel sick, then you pass out, then you die.

AurorusBorealus Mon, 05/14/2018 - 14:32 Permalink

It is said of generals that they always fight the last war.  This statement should apply to investment bankers who roll out charts, based upon a section of data which they select specifically to bolster their thesis (rather than basing a thesis upon an aggregate accumulation of data in general).  So if the data is selected to support the thesis and the thesis is not based upon the data, from whence does the thesis originate?  It originates from "historical experience," so extensive as to extend back 40 entire years, since the end of the U.S. gold-standard and the Bretton Woods system.... 40 whole years.

Surely the economic history, captured neatly in a handful of Cartesian coordinate charts plotting the movement of two data points over the past 40 years contain the entire set of possibilities for human conduct, geostrategic outcomes, planetary motions, geothermic activity, climate, innovation, and economic endeavors.  What could possibly go wrong with trying to predict the future based upon data that does not extend back more than two generations and is limited to plotting one point of datum against another and then drawing a line between the various points?  Moreover, how could a group of economists in their 20s and 30s, who have little education except that provided by the charts and tables of modern economics possibly be wrong?  Everyone agrees, so it all must be true.  It does not matter that most of the people who agree were taught in the same way, have the same very limited background of knowledge, and are not old enough to remember anything that occurred before their first data point.

There can be no Protestant Reformation and 30-years war between religious groups, because that did not happen in the past 40 years.  Discard that possibility.  Their can be no global war.  It has not happened in the past 40 years.  The dollar is the world's reserve currency.  It has always been in the past 40 years; therefore this must always be true (otherwise the charts and tables are completely meaningless). 

Demand for dollars must be based on dollar-denominated debt, because those are the charts that we have and those are the two data points that we have correlated.  All other data points are irrelevant.  They must be, or our chart is wrong.  The demand could not have any relation to commodity purchases or the needs of international trade.  Banks do not need to purchase oil, raw materials, or labor to produce finished products.  Likewise banks do not need to purchase finished goods from abroad to sell to customers at home.  And if the banks do not need something, it is not very important to bankers.

So it makes no difference if bilateral trade agreements make dollars less useful and less necessary to international trade.  The formation and growth of the Petro Yuan makes no difference.  U.S. sanctions on Iran, Venezuela, Russia, and countless other countries, which encourage countries to stop using dollars for international trade, are irrelevant to the two data points on this chart.  The two data points of a Cartesian coordinate system and the vast knowledge of 30-year old economists, who learned nothing except economics, are all that is needed to predict the future.

The astrologers of ancient Babylon would have agreed wholeheartedly with the modern investment banks and modern economists.  Of course, the tablets of the ancient Babylonian astronomers extended back centuries, and in that, their predictions, based upon plotting the movement of planets on a 2-dimensional coordinate system were more reliable indicators of the future than those of the modern economists.  Now, I am off to study the ancient Babylonian star-charts.  I am certain that these contain the data necessary to determine the outcome of the next Middle Eastern war.

snblitz Mon, 05/14/2018 - 14:45 Permalink

Might we the people be better off without all the financial engineering?

"Financial engineering" is a simply a cover for theft.

Dishonest money robs you of everything including your investments.  So you make 7% annualized return over 30 years on your $100K "investment" while 98.4% of your purchasing power disappears.  Did you really "make" anything?

besnook Mon, 05/14/2018 - 16:13 Permalink

is there turmoil in the market or turmoil in the dollar? is the current levitation a necrofeline vertical ricochet? is there really a market downturn if dollar slack is being taken up by other currencies? the yuan. exponential curves go down, too.

scubapro Mon, 05/14/2018 - 20:47 Permalink


the end is nigh.

but the timing of 'nigh' can vary.     3rd and 4th quarters of 2018 will be very then we should see how US gdp growth will be flatlining, 'tax reform' impacts will be dust in the wind (the biggest impact should be happening NOW, 5 months of 'bigger paychecks'; 6 months of capex planning/spending; where are all the bonuses and raises to support the "tight" labor market?? by spet 30, all will be looking around for hopes of growth, while holding equities at 20x ttm, and emerging mkts not able to meet their $ interest burden.

but maybe if we all buy robts for the home and order ev'thing from amzn, we can winnow this economy down to a few clicks/day and posting emoticons during american idol/kardashians.  that would surely fill the definition of "robust" US eocnomy as I read Blackrock describe it today