FX Dashboard: Turkey’s Assets Descend into Familiar Turmoil

The US dollar strengthened this morning as a cautious tone pervaded over the markets on the back of the US and its allies imposing sanctions on Chinese officials related to human rights abuses. While recent bouts of volatility have been driven by US long-end yields rising, this morning they moved lower in line with the overall heavy sentiment.

The dollar index was up 0.4%, while EM currencies were weaker by 0.3% on average. Oil prices continued to slide with Brent going from USD 70/bbl earlier this month to just over USD 60/bbl now, making the Russian ruble (RUB) the worst-performing currency as it depreciated 1.7%. The Turkish lira (TRY) was weaker by almost 1%, not the worst performer but it still garnered all the attention.

The 200 bp rate hike by the Turkish central bank last Thursday came as a complete surprise to the market, resulting in a sharp rally in the currency. However, the subsequent firing of the central bank governor caused the lira to go from 7.2/USD to 8.4/USD before settling around 7.9/USD.

We have been skeptical of the country’s macroeconomic policies for some time as they tend to go in cycles starting with highly accommodative monetary policy leading to inflation becoming unanchored and spilling over to the currency and ending with aggressive monetary policy tightening which reverses some of the excesses until the cycle starts again.

The underlying reason behind the haphazard management of monetary policy is that the central bank is under political pressure to stay accommodative but is eventually forced to act to anchor inflation expectations. The chart below overlays the ending of the term of each of the last three central bank governors on the path of the policy rate and the currency. Both Murat Çetinkaya and Naci Ağbal tried to address rising inflation expectations and weakening currency by maintaining interest rates at elevated levels, with the former acting belatedly and the latter staying ahead of the curve. In contrast, Murat Uysal tried to address the currency weakness via interventions, thus depleting the country’s international reserves. Despite differences in their approaches, all of them ended with the same fate.

From a strategy perspective, as we highlighted in our note last week, the proactive approach by the central bank governor led us to put aside our skepticism and look at the lira as a short-term opportunity. Unfortunately, the positive part of the cycle turned out to be even shorter than we expected.

Looking ahead, following the 10% correction over the past few days combined with the policy rate of 19% and real rates the highest among major countries makes the currency very attractive. However, given the current high volatility, we cannot preclude the risk of prohibitive capital controls being put in place. This could happen if, for example, locals start adding to their dollar positions instead of using the current levels to exit. As such, we would wait for the volatility to come off the peak, even if it means a somewhat worse entry point.

In terms of the contagion risks, we would deem it to be low as we would expect the correlation of TRY with EM to once again drop to the lows of last year (see FX Dashboard: Lira is an Idiosyncratic Play).

Data Source: Refinitiv

Best Longs / Best Shorts

• From our lists of underperformers in the attached FX Dashboard, we removed the Thai baht (THB), the Korean won (KRW), and the Hungarian forint against the euro (EURHUF) as their z-scores receded.
• The list of underperformers now consists of only the Peruvian sol (PEN) and the Polish zloty against the euro (EURPLN).
• To the list of outperformers, we added the Indian rupee (INR) as its z-score based on 3m changes dropped below -1.

Best Crosses

• Our list of preferred relative-value trades comprises of Long Polish zloty (PLN) vs Short the Canadian dollar (CAD) or the British pound (GBP).
• The 3m expected returns for these pairs are just over 7% (not annualized), assuming mean reversion.