Contagion: Clear in Retrospect, Impossible to Accurately Forecast, Can Happen at Any Time

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via iforex.in:

It’s been several years since the markets started using the word contagion.  During the European debt crisis, this word was used constantly as traders worried that issues with Greece and Spain and Portugal would spread across Europe. Today, the markets are discussing another contagion as the Turkish Lira plunged 10% moving up to a higher of 6.25 versus the greenback before tracing some of its losses and settling near the 5.93 level. The close on Thursday was closer to 5 Turkish Lira per US dollar. The catalyst that drove the Lira lower seemed to be a lack of government concern that investors are waiting for an outline of a new economic plan.

The Dominos Are Beginning to Fall

When a currency tumbles like the Turkish Lira it does not decline in a vacuum. The credit default swaps, which traders use to measure the cost of insuring Turkish assets, dropped in value making it much more expensive to buy protection.  Other than Venezuela, its now the most expensive protection in the world. Finding a way out for the Turkish government will not be easy, but going to the International Monetary Fund and asking for help and new conditions on loans would be a good first step.  The country also needs to impose capital controls not allowing investors to just take their money and run. This would stop a run on the banks which will likely follow. There needs to be reform and austerity, guiding investors to a way that can purchase government debt without having it evaporate.

The Central Bank of Turkey needs to act. There next policy meeting is not until September 13, and time is of the essence. A boost of short-term rates above 30%, would be a wake up call that would incent investors to invest and discourage an short-positions in its currency.  Obviously, this would be very expensive for the Turkish central bank, but acute action is needed.

Contagion

The ECB pointed to a few banks including BNP Paribas and BBVA that has substantial exposure to Turkish banks. These banks will begin to falter if things get worse in Turkey. Additionally, the Euro broke down through support levels moving as low as 1.1430 before stabilizing.  Yields in the periphery of Europe are moving higher while Bund yields started to move lower. Equity markets in Europe are starting to trade under pressure, which could be the beginning of contagion.

 

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