When central banks err on the side of monetary tightening at the peak of a credit cycle, the most highly-levered assets are the first to blow up. In this case the so-called “carry currencies,” the emerging market currencies offering government bond yields in excess of 6%, are the canaries in the coal mine. Miners noted that canaries would fall dead from gas buildup before humans noticed the problem. Sharp declines in the value of carry currencies during the past week is a flashing yellow signal in world markets.
Here’s the story in three charts. The first shows (on a normalized scale) the number of local currency units per US dollar since April 18, plotted against the price of US Treasury 10-year note futures. The dots represent one-minute intervals. As the price of the Treasury future declined (moved toward the left on the horizontal axis) the number of local currency units per dollar rose (that is, the value of local currency declined). The simultaneous collapse of all four of the canaries is impressive, given the varied (and significant) political news affecting all four markets. The ruble was whipsawed by the on-again, off-again reports of US sanctions against Russian companies. The Turkish lira was buoyed temporarily by President Erdogan’s announcement of early elections. The Mexican peso was plagued by polls showing a likely electoral victory by an extreme left-wing populist in the July presidential election. And Brazil’s political future remains extremely uncertain.
Nonetheless, stepping back from the day-to-day fluctuations in response to political news, we see a major move in the value of all the carry-canaries in response to the US Treasury yield.
Treasury yields have been creeping up for weeks in response to rising commodity prices. The inflation-expectations component of the Treasury yield, or so-called breakeven inflation, has traded pretty closely with major commodity indices.
What changed during the past week is a market perception that the Federal Reserve will respond to commodity-driven price increases by tightening monetary policy. The third chart shows the expected federal funds rate in 12 months (based on futures markets) against the so-called “real” component of the Treasury bond yield (the yield on Treasury Inflation-Protected Securities).
This picked up sharply during the second and third weeks in April. And that is what is killing the canaries.
The trouble is that the Federal Reserve and other central banks have been waiting for the ghost of inflation past during the past five years, to no avail. The recent jump in oil prices probably has more to do with geopolitical fears and the success of OPEC and Russia in supporting prices than any change in demand for oil. The misguided inflation model at the Fed encourages oversteering in monetary policy, and that’s what the market fears.
If the emerging-market canaries go, other highly-levered sectors of the world economy, for example highly-levered firms financed by high-yield debt after private equity takeovers, as well as a great deal of commercial real estate will go along with them. Depending on how far the central banks oversteer, things could get nasty during the next several months.