The price action in the financial markets today is a classic example of how geopolitical risks can overshadow economics. This morning’s U.S. economic reports were mixed and in Germany, business confidence increased. However investors are unwinding carry trades as the growing risk of an international response to Syria drove most of the major currencies lower against the U.S. dollar and Japanese Yen.

Despite the decline in stocks this month and the downside surprises in U.S. economic reports, consumer confidence increased in the month of August. The Conference Board’s consumer sentiment index rose to 81.5 from 81 to its second highest level since January 2008. Manufacturing activity in the Richmond region also ticked up but house prices grew at a slower pace in June with the S&P CaseShiller index rising 0.89% vs. 1.04% the previous month.

New Lows in Emerging Market Currencies – Domestic Policies Make Things Worse

Meanwhile emerging market currencies continued to collapse with the Indian Rupee and the Turkish Lira falling to record lows against the U.S. dollar. Risk aversion and concerns about Syria contributed to the sell-off but domestic policies led the moves lower. In Indian, markets were punished after Parliament approved a $20 billion plan to provide cheap grain to the poor. This new legislation will touch nearly 70% of India’s 1.2 billion population. No one will argue that food for the poor is desperately needed in India but the rice will be highly subsidized and this raises concerns about the government’s ability to control spending or meet its fiscal deficit targets. In reaction, investors drove the Rupee (INR) down more than 2.8%. Despite widespread initiatives, India has a serious problem with investor confidence. Too many local investors prefer to invest abroad than domestically and as the currency continues to weaken, the Reserve Bank of India will need to announce additional measures to stabilize their markets.

The Turkish Lira also dropped 1.9% to a fresh record low against the U.S. dollar after the central bank said they wouldn’t raise interest rates. While they have sold dollars in an attempt to offset the slide in the TRY, they view the drop as temporary and as such, don’t want to alter their plans to keep interest rates at 6.75% until inflation falls to 6.2% (it is currently at 8.8%). Unfortunately a falling currency will make it very difficult for inflation to ease and poses an upside risk to prices. The central bank prefers to defend the lira through intervention but if inflation starts to move higher because of a weakening currency, they may have not choice but to raise rates.

At the end of the day, emerging market central banks have a long battle ahead of them and one that will be difficult to win on their efforts alone.

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