FX Dashboard: Turkish Lira Takes the Helm as the Worst-Performing EM Currency

Following the surprise rate cuts by the central bank in late 2021, the Turkish lira (TRY) weakened considerably as it went from 8.6/USD to its worst level in December, 16.8/USD. In response, the government proposed a scheme to hedge lira deposits against currency depreciation, which helped the currency recover, albeit with significant volatility. The lira then stabilized until Russia’s invasion of Ukraine. After the initial bout of weakness following the invasion, it then stabilized again through early May. Since then, however, the lira has depreciated sharply beyond the weakest level in December and has taken the mantle as the worst-performing currency in EM this year – see the charts below.

Data Source: Refinitiv; Note: EM FX = equally weighted index of spot returns of 21 currencies excluding the Russian ruble

Data Source: Refinitiv; Note: EM FX = equally weighted index of spot returns of 21 currencies excluding the Russian ruble

Data Source: Refinitiv; Note: EM FX = equally weighted index of spot returns of 21 currencies excluding the Russian ruble

The poor performance of the lira can be directly attributed to the central bank refusing to raise rates even in the face of sharply rising inflation. Real rates have thus turned sharply negative, weighing heavily on the currency. Indeed, the currency appears to have entered a vicious cycle with inflation. More specifically, going into the factors driving the currency performance:

• Worsening inflation outlook:
  • High prices of commodities, particularly energy which the country imports, along with the currency depreciation are leading to accelerating inflation. Headline inflation soared to 73.5% YoY in May, the highest since 1998. Food and energy prices have played a role, but even core inflation reached 56% YoY. To make matters worse, Turkey raised natural gas prices for households by 30% last week, adding to a 35% increase the previous month. Power prices for industries were raised by over 15% and regulatory changes are underway for further increases.
  • Inflation expectations have deteriorated markedly. In the central bank’s monthly survey, CPI expectations for the end of the year rose sharply to 58% from 46% in the previous month. In a year, inflation is expected to be at 33% and in 2 years it is expected to be at almost 20%.
  • Inflation breakevens are at an even worse level with 1-year implied inflation above 50% and 2-year at 42% – see the chart below. The breakeven curve shows inflation falling to 20% no earlier than 10 years.

Data Source: Bloomberg

• Central bank reluctant to hike: Monetary policy is set to remain highly accommodative. Indeed, under political pressure from President Erdogan, the central bank cut its policy rate by 500 bp to 14% last year despite no sign that inflation was decelerating. The policy is unlikely to shift as the president has dismissed three previous central bank governors who sought to raise interest rates to contain inflationary pressures. Not only are real rates turning more negative as a result, but the interest rate gap between Turkey and the US is narrowing as the Fed has started raising rates, putting even more pressure on the lira.
• Turkish residents prefer FX deposits: During similar episodes in the past, Turkish residents sold their FX deposits when the lira reached extreme levels, which helped stabilize the currency. Not this time. Despite the government’s efforts to encourage lira deposits by providing hedges against currency depreciation, residents continue to hold over 60% of their deposits in foreign currencies.
• Falling FX reserves: With monetary policy hurting rather than helping the currency, interventions have been used as a tool to try and stabilize the lira. It’s not surprising, therefore, that gross international reserves have dropped from USD 86 bn in November 2021 to USD 53 bn as of May 2022. Netting out the expected FX outflows and currency swaps, which are used for interventions, leaves FX reserves at -34 bn, excluding gold and SDRs.
• Rising short-term external debt: The low levels of international reserves are concerning as the short-term external debt is quite high. From a high of USD 192 bn, Turkey’s short-term external debt dropped to USD 167 bn at the end of 2021. However, it has started rising again and reached USD 182 bn as of March, which amounts to 23% of GDP.
• Fiscal slippage: The government’s FX-linked lira deposit program worsened the budget deficit by USD 1.3 bn. Indeed, as the currency continues to weaken, the cost of the scheme will continue to rise. Bloomberg consensus expects the fiscal deficit to deteriorate to 4.6% of GDP from 3.2% in 2021.
• Current account worsening: High commodity prices, particularly energy prices, are weighing on the current account. The current account deficit is expected to widen from 2.2% in 2021 to 3.8% of GDP this year, which is worse than the 5-year average of 3.2%.
• Slowing economy: Accelerating inflation is taking a toll on consumer demand, leading to expectations of economic deceleration. In the central bank’s monthly survey, the GDP growth is forecasted to slow to 3.3% this year from over 10% last year.
• Rising political uncertainty: Support for Erdogan is at 44.4%, and for his Justice and Development Party (AKP), it has dropped to 26.5%, according to a recent poll by MetroPoll. Moreover, 60% of residents say they have lost faith in Erdogan. Elections are scheduled for June 2023 but with the majority of the country supporting early elections opposition parties are taking steps accordingly. Political uncertainty is thus set to rise. As an example, the popular mayor of Istanbul, who is a potential presidential candidate, is facing prison time on the pretext that he insulted election authorities.

With the unorthodox policy framework unlikely to change, the lira has no anchors and should therefore continue to depreciate. The lira is uncorrelated with the broad EM currency universe – see the chart below – and is likely to stay that way for now.

Data Source: Refinitiv; Note: EM FX = equally weighted index of spot returns of 21 currencies excluding the Russian ruble

Model-Based Best Longs / Best Shorts

• From the list of underperformers based purely on my models in the attached FX Dashboard pdf, I removed Hungarian forint against the euro (EURHUF) and Korean won (KRW) as their z-scores receded.
• The list now consists of Chinese yuan (CNY), Taiwan dollar (TWD), Malaysian ringgit (MYR), and Thai baht (THB).
• On the list of outperformers, I replaced Brazilian real (BRL) with Polish zloty against the euro (EURPLN), Mexican peso (MXN), and Czech koruna against the euro (EURCZK).

Model-Based Best Crosses

• The list of the preferred relative-value trades based purely on my models changed to Short MXN or Polish zloty (PLN) or BRL vs Long Japanese yen (JPY).
• The 3m expected returns for these pairs are in the high range of 13-19% (not annualized), assuming mean reversion.