While the market is (finally) paying attention to the accelerating Turkish collapse and specifically the risk of contagion to Europe, Asia, and ultimately, US capital markets, the truth is that this crisis has been a long time in the making. In fact, the first break in the “strong Emerging Market” narrative emerged in late April when as a result of rising US interest rates the dollar surge began in earnest (facilitated by China’s first easing announcement on April 17), which in turn sent the both EM currencies, and EM debt reeling…
… to be followed shortly by the plunge in the biggest EM currency of all: the Chinese Yuan.
And as we highlighted in early May, BofA’s Chief Investment Officer Michael Hartnett observed that higher US rates finally caused a higher US dollar (courtesy of the PBOC), at which point “EM started to crack.” But while many had pointed at the collapse in the Turkish Lira, the Argentine Peso, and the Indonesia Rupiah, as cracks in the EM narrative, the truth is that many of these are idiosyncratic stories.
So how could one decide if the Emerging Market turmoil – whether started by Turkey, Argentina, Russia, China, or any other EM country – was set about to sweep across the entire sector, and result in DM contagion? According to Bank of America the answer was simple. This is what Hartnett said in early May:
“EM FX never lies and a plunge in Brazilian real toward 4 versus US dollar is likely to cause deleveraging and contagion across credit portfolios.”
In other words, to Bank of America, the best indicator of imminent emerging market turmoil is shown in the chart below dated circa three months ago: if and when the BRL starts sliding, and approaches 4, it may be a good time to panic as contagion is about to go global.
Fast forward to today, when in light of the latest emerging market turmoil, the Brazilian real – which plunged as low as 3.9287 vs the dollar after the Brazilian FinMin said he saw “no need to intervene in FX markets” – is now on the verge of crossing this key level that has been a virtually guaranteed predictor of contagion.
And just in case, Hartnett also laid out a secondary “fail safe” EM-stress indicator:
Tremors in the periphery: 3% + rally in US$ has caused EM tremors (ARS, INR) at a time of peak EM debt/equity inflows ($371bn)…EMB <107.50 contagious
This means that once EMB, the JPM Emerging Market Bond ETF, drops to 107.50 – the level it hit right after the Trump election – it will be time to get out of Emerging Dodge.
Where is the EMB today? It just dropped to 105.75, the lowest level since February 2016, and validating the negative signal about to be launched by the BRL.
So while everyone is hypnotized by the Turkish lira, keep a closer eye on the Brazilian Real: once it crosses 4, the real fireworks begin.