Markets To Test Central Bank Resolve

As we expected ( see 'Europe FX & Fixed Income Strategy', August 19), the Central Bank of the Republic of Turkey (CBRT) hiked the upper bound of its interest rate corridor by 50 basis points on August 20, marking the second consecutive month of tightening measures aimed at stemming lira depreciation. Although our call was out of consensus, with none of the eleven economists surveyed by Bloomberg forecasting a hike, investors were disappointed with the move. The lira came under intense selling pressure once again on August 21, reaching TRY1.966/US$, just shy of its record low of TRY1.974/US$. This prompted the CBRT to announce that it would only offer liquidity at the upper bound of the corridor, at the overnight lending rate of 7.75%, for an indefinite period of time.

While this should marginally bolster the lira in the short term, we continue to believe that a more decisive hike to the entire interest rate corridor would be the most effective way to stabilise the currency, which will come under sustained selling pressure in the context of waning global demand for emerging market assets due to Turkey's large external deficits. As long as the CBRT postpones more decisive action, markets will continue to test its resolve in supporting the currency.

With interest rates heading higher and expectations for economic growth beginning to converge towards our below consensus forecasts in 2013 and 2014, the Istanbul Stock Exchange Index (ISE-100) appears to have further downside as it approaches a key short-term technical resistance level. Heavily weighted towards the banking sector, which has become increasingly dependent on external financing over the past few quarters ( see 'Risks Mount as Elevated Loan Growth Continues' April 25), the prospect of capital outflows and slowing domestic credit growth will weigh heavily on growth and profitability in the sector.

Sell-Off Continues Despite Tightening
Turkey - TRY/US$ Exchange Rate

As we expected ( see 'Europe FX & Fixed Income Strategy', August 19), the Central Bank of the Republic of Turkey (CBRT) hiked the upper bound of its interest rate corridor by 50 basis points on August 20, marking the second consecutive month of tightening measures aimed at stemming lira depreciation. Although our call was out of consensus, with none of the eleven economists surveyed by Bloomberg forecasting a hike, investors were disappointed with the move. The lira came under intense selling pressure once again on August 21, reaching TRY1.966/US$, just shy of its record low of TRY1.974/US$. This prompted the CBRT to announce that it would only offer liquidity at the upper bound of the corridor, at the overnight lending rate of 7.75%, for an indefinite period of time.

While this should marginally bolster the lira in the short term, we continue to believe that a more decisive hike to the entire interest rate corridor would be the most effective way to stabilise the currency, which will come under sustained selling pressure in the context of waning global demand for emerging market assets due to Turkey's large external deficits. As long as the CBRT postpones more decisive action, markets will continue to test its resolve in supporting the currency.

Sell-Off Continues Despite Tightening
Turkey - TRY/US$ Exchange Rate

With interest rates heading higher and expectations for economic growth beginning to converge towards our below consensus forecasts in 2013 and 2014, the Istanbul Stock Exchange Index (ISE-100) appears to have further downside as it approaches a key short-term technical resistance level. Heavily weighted towards the banking sector, which has become increasingly dependent on external financing over the past few quarters ( see 'Risks Mount as Elevated Loan Growth Continues' April 25), the prospect of capital outflows and slowing domestic credit growth will weigh heavily on growth and profitability in the sector.

Further Downside Potential
Turkey - Istanbul Stock Exchange Index

Should the release of US Federal Reserve minutes on August 21 indicate a more dovish tone than anticipated regarding the eventual tapering of quantitative easing, we see the potential for a short-term rally in Turkish assets due to their heightened sensitivity to expectations of monetary policy normalisation in the US. However, we continue to believe the Fed will begin to slow asset purchases in coming months, which combined with Turkey's sizeable external deficits, implies that before the end of 2013 the CBRT will have to hike more aggressively to avoid a disorderly sell-off in the lira.

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This article is tagged to:
Sector: Country Risk
Geography: Turkey, Turkey, Turkey, Turkey
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