The US dollar surged last week, with the Dollar Index rising 1.25%, the most since April. The dollar is being boosted by two drivers. The first is the policy mix and interest rate divergence.The other is the intensification of pressure on emerging markets. Turkey has a disastrous combination of more fundamentals, large short-term foreign currency debt obligations, unorthodox policies, and the lack of credibility. On top of this, Erdogan has antagonized the US when it is keen to flex its muscles.

The lira collapsed 21% last week and as the headlong plunge accelerated risk assets fell out of favor. This included other emerging markets, equities, and peripheral European bonds. It did nothing for gold, which edged lower, extending its drop for a sixth consecutive week. The US provided more fodder by imposing sanctions on three countries last week, a new axis of evil (?) – Russia, Turkey, and Iran.

One of the key questions facing investors is whether Turkey is the canary in the coal mine the way Thailand was in the 1997-1998 Asian Financial Crisis. Recall that that crisis was one in which fixed exchange rate regimes were overwhelmed. That is not an issue now, though as we have seen floating rate adjustments can be quick and sharp as well. Still, a judgment must be made about the likelihood that the intense risk-off mood ahead of the week is sustained. Given the magnitude of bank exposures and the fact it is many investors had hedged and/or reduced exposure to Turkey already, we do not expect the market to be able to sustain the pace we saw at the end of last week. If an attempt to extend the pre-weekend moves in early Asia on Monday falters, then the markets recover.

While our outlook for the dollar remains constructive, it is over-extended. All the major currencies finished last week outside their Bollinger Bands. Momentum traders may try to push further, but we suspect that before the dollar can advance much more, it needs to consolidate its recent gains. The late dollar longs may be in weak hands, but the corrective or consolidative phase need not be deep or long. It is not unusual for the markets to retest the breakout. The liquidation by the momentum players may provide an opportunity for stronger hands in the investment community.

One way to express this view is in the crosses that were driven by the arguably exaggerated risk-off move like euro-Swiss or euro-yen. The euro fell to its lowest level against the Swiss franc since last August near CHF1.1340.T o be sure, it is not just erosion of Turkey that weighed on the cross, which fell for the fourth consecutive week, but the dramatic move in the second half of last week saw the euro move three standard deviations from the 20-day moving average. A return to the breakout gives the euro scope for a 1% gain. The euro’s decline against the yen also saw it test three standard deviations from the 20-day average.