With the lira falling over 6% in the last three trading days, speculation as to whether the Central Bank of the Republic of Turkey would continue cutting rates at today’s meeting was rife. The pre-emptive pricing in USDTRY proved to be correct, as the central bank followed the guidance of President Erdogan and cut rates by a further 100bps to bring the policy rate to 15%.
The initial reaction in the lira was mixed, however, with a rally first taking place on headlines that the easing cycle would be assessed in December, before the broader statement was digested by markets and sent USDTRY back close to the 11.00 handle. The renewed pressure on the lira was due to the terminology around the December forward guidance, which presented a much looser commitment to halting the cutting cycle than headlines suggested. By throwing a bone to markets in the form of December rate guidance, the CBRT narrowly avoided a full blown currency crisis, but speculation over the lira and rates in Turkey will remain elevated. In our view, USDTRY is just one Erdogan headline on inflation away from sliding through the 11 handle.
With the central bank still subject to intense political pressure and the inflationary backdrop remaining unfavourable given recent TRY declines, we are keeping a close eye on offshore liquidity conditions and whether they will be altered in an attempt to trim aggressive short positioning in the lira.
Additionally, we will continue to monitor broader financial conditions in Turkey and banking sector risk, as continued pressure on the currency could result in increased financial stress and potentially a credit crunch. The first signs of increased financial stress are evident in the USD Turkish sovereign curve, where front-end rates have already risen over 15bps on the day.
Predicting the endgame in Turkey is difficult in such volatile conditions, although the two pathways out of the current climate are clear. Either the central bank pushes back on the political pressure to lower interest rates, and in turn tries to appease markets and wait until transitory elements of inflation begin to subside before cutting again, or the central bank tries to navigate a softer easing cycle via more palatable communications, smaller and less frequent interest rate cuts, and altering liquidity conditions to soften the TRY impact. For now, the central bank hasn’t indicated which exit strategy it favours, thus leaving the lira exposed to increased short speculation.
USDTRY stops short just before the 11.0 handle but volatility remains rife as the central bank doesn’t show its preferred exit strategy from the current easing cycle despite suggesting it may wind down
Author: Simon Harvey, Senior FX Market Analyst