A Different Flavor Of Curve Inversion And Some Thoughts On The EM Exodus

by: The Heisenberg

I want to show you an inverted curve, but probably not of the variety you're used to talking about.

I also want to talk about what that inversion means in the context of the exodus from emerging market assets.

Oh, and I'll also bring you one bank's answer to the question: "How bad can it get for EM outflows?"

One of the things I like most about my post-Balvenie reality is that I can remember things I said a month ago.

As regular readers know, I'm pretty fond of quoting myself (because nothing says "self-absorbed" quite like habitually referring to your own proclamations), so being able to recall analysis that's more than week old greatly expands my mental Rolodex.

Well, back on May 23, in something called "Requiem For A Meme", I highlighted the following chart:


That's 1-month implied volatility on the lira, and although it's come in a bit following the election and all of the steps the central bank has taken to shore up confidence, what you should note there is the effect that had on carry. Here's what Bloomberg wrote at the time:

Potential carry trade in Turkey’s currency, based on interest-rate differential adjusted for volatility and dollar-funding costs, [has] plummeted to the lowest since January 2017.

I was reminded of that chart on Wednesday afternoon. While perusing Bloomberg's public website just prior to the close on Wall Street, I ran across a piece by Luke Kawa (one of their rising stars) called "This Inverted Market Curve Is Already Causing Investors Pain."

Whenever you hear "inverted curve" in 2018, you automatically think about the U.S. yield curve, which is in the habit of making new cycle lows seemingly every day as risk-off sentiment manifests itself in a bid for the long end, while a determined Fed keeps the short end from rallying. That's not helping the financials. In fact, the Financial Select Sector SPDR ETF (NYSEARCA:XLF) has fallen for a truly remarkable 13 consecutive sessions:


But I'm not talking about the yield curve here. Rather, I'm talking about the yuan (NYSEARCA:CYB) volatility curve.

If you read my Wednesday morning post (or, if you're not a fan of mine, you could have read about it anywhere because it's one of the big market stories right now), you know the Chinese currency is weakening at the fastest pace since the 2015 devaluation. In that linked post, I go into quite a bit of detail about what's causing the yuan to weaken, so I won't rehash it all here.

What I would briefly add is that the offshore yuan fell again on Wednesday, marking its tenth consecutive decline, and as Bloomberg's Ye Xie noted on Wednesday afternoon, "even with the recent decline, the yuan is down only 1.5% against the dollar this year, leaving it as the 7th best performing currency among 31 majors." That latter point suggests this could easily get worse, especially considering the PBoC seems content to sit back and watch for the time being.

Ok, so below, find the yuan volatility curve inversion I mentioned above plotted with the S&P (my chart isn't quite as aesthetically pleasing as the one in the Bloomberg article, but it gets the job done):


Why does this matter? Well, for the same reason that the lira chart mattered last month. Here's a quote from a note by Intellectus Partners' Ben Emons, cited in the Bloomberg piece linked above:

The higher short-term FX volatility, the harder to currency hedge international bond and stock portfolios. That leads to a ‘return to the base’ by reducing risk such as emerging market exposure and dialing down FX positions to the home currency.

In other words, it prompts traders to unwind exposure to emerging markets. The MSCI EM FX index fell again on Wednesday. It was the tenth decline in a dozen sessions:


The backdrop here is challenging, to say the least. EM is coping with China jitters, trade war concerns and a hawkish Fed. That is a truly toxic combination, especially considering how crowded some of these trades became during the QE years.

In this context, Goldman was out on Wednesday with a lengthy post on EM flows, and while they generally take a more benign view of things in light of their highly nuanced analysis of flow dynamics, they do admit that while a dour take "runs counter to [their] view that fundamentals drive flows, for investors who are particularly concerned from a flow perspective, the numbers can indeed still be daunting."

That quote is from a section called "Outlining the 'Severe Bear Case' for EM outflows," and here's what that "severe" case looks like:

Looking again at the cumulative inflows surveyed by EPFR, we would assume that the majority of the money that came into EM over the past 2 years comes back out and returns us to the flow levels of mid-2015. This would put us back towards similar (but below) net flow levels of 2010 across all EM asset classes and essentially assumes that the majority of “QE-inspired” inflows reverse (these calculations do not include valuation effects). Under these assumptions, we would see roughly $65 billion of EM equity outflows, $45 billion of EM credit outflows, and $20 billion of EM local debt outflows.

Again, I want to emphasize that this is not Goldman's base case - not even close. But if you look at the projections in those charts, what you should note is that the numbers in the right pane would be on top of the 19% selloff we've already seen in EM equities (EEM), on top of the 95 bps widening we've already seen in EMBI and on top of the 56 bps rise we've already seen in yields on local debt. In other words, that would be an egregious scenario with knock-on effects that are almost impossible to predict ahead of time in terms of second-order ramifications for sentiment, etc.

Mercifully, Goldman does not find compelling statistical evidence to support the narrative that rising short rates in the U.S. will compel investors to simply abandon EM in favor of what amounts to cash. That is, if you're worried about the substitution effect that presumably occurs when cash becomes a viable asset class again, don't. At least not as it relates to EM flows.

The overarching point in all of the above - which I certainly hope is clear - is that recent turmoil in Chinese assets, and particularly in the yuan, has exacerbated existing pressure on emerging markets from the trade tensions and the hawkish Fed.

Something has to give here, and my guess would be that if the Trump administration doesn't move quickly to adopt a decisively less adversarial stance on trade with China, Jerome Powell is going to have to give the market some kind of sign that the Fed is prepared to put the brakes on. That would cause the market to perhaps reprice the Fed path and would remove some of the upward pressure on the dollar (UUP).

In the absence of either of those things (i.e., Trump striking some kind of compromise with Beijing, or the Fed sending a dovish signal), EM is likely to remain under pressure. And what I would encourage you to be aware of is that the administration's attempt to bail out markets on Wednesday by taking a less aggressive approach to restricting Chinese investment in U.S. industries was faded aggressively. Here's an annotated chart of S&P futures:


To me, that signals that the bar has been raised in terms of what counts as "conciliatory" on trade negotiations.

Nothing further for now.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.