Global market volatility returned with a vengeance last week and this time the issue didn't involve US debt ceilings and assorted European debt crises.

Instead the problem centred on emerging market economies and the recent plunge in their respective currencies.

In today's editorial we will provide some background on the events of last week and assess their impact on financial markets.

Background

The market's sudden focus on emerging markets was sparked by Turkey and the plunge in its currency, the Lira.

Turkey, a country that straddles Southern Europe and the Middle East, has been gripped by protests against a government said to be mired in corruption.

The protests have destabilised the government and focused attention on the nation's economic problems, including a ballooning current account deficit.

A nation with a current account deficit is one that essentially imports more than it exports, and so is reliant on foreign capital to finance the deficit.

The US Federal Reserve has begun winding down its stimulus program, and this has contributed to a flight of international capital away from Turkey and back to the US.

The ensuing capital flight has seen the Lira take a pounding over the past month and a half, as the following chart illustrates.

The figures are indexed with a base value of 100, so the final figures on the right-hand side of the chart are presented as a percentage change from 100.

The green line represents the US dollar versus the Turkish Lira (USD/TRY), the currency pair having soared approximately 17% in the past six months.

We have also included on the chart the US dollar versus the South African Rand (USD/ZAR). South Africa is another emerging market economy experiencing volatility.

The USD/ZAR has risen approximately 13.5% over the last six months, highlighting the multi-headed nature of this new currency market volatility

For comparative purposes, we have graphed the US Dollar Index (DXY) at the bottom of the chart (white shaded line). The DXY is an index of the value of the US dollar relative to a basket of foreign currencies.

As we can see the DXY has essentially unchanged over the past 6 months, further suggesting that this currency market instability is centred mostly in the emerging markets.

Market impact

Currency markets have historically fluctuated more than equity markets, and emerging market currencies have experienced bouts of volatility before without sparking a full-blown financial crisis.

The most recent reference point is the 1997 Asian crisis, which ignited collapses in the currencies of a number of East Asian nations and ultimately slowed global economic growth.

The currency collapses during the 1997 crisis were far more severe than what we have seen so far in Turkey and South Africa.

The early reaction from markets to the latest currency flare up is a concern, with global equity indices retreating significantly over the past week.

Below we graph the benchmark US index, the S&P500 (green line), and the Chicago Board Options Exchange Market Volatility Index ('VIX', represented by the white shaded line).

As the circled section of the chart shows there was a spike in volatility last week, which corresponded with a sharp drop in the S&P500.

It is worth noting that the recent volatility has so far failed to match other volatility spikes in 2013.

This is not to say the volatility won't become worse over the following weeks. Emerging market currency volatility is a serious matter given the threat of contagion, which may spread to larger, more important, economies like China.

However, it is far too early (and this stage doubtful) to tell whether we will witness a re-run of the 1997 Asian crisis, which is what the market is fearing right now.

As mentioned in previous editorials, trading volumes are traditionally weaker during the holiday months of December and January.

A continuation of this volatility into February would be a far more worrisome signal, particularly if it coincided with a tightening of Chinese credit market conditions.

Weekly Market Wrap: An Emerging Crisis is a post from: Australian Stock Report Market Pulse Blog