News & analysis

Emerging market FX has been trading broadly on the backfoot over the last few weeks due to a deterioration in risk appetite, fuelled by growing Covid cases in major economies. Despite this, the Turkish lira continues to stand out to investors within this space, with the currency in free-fall after a prolonged period of credit growth, heightened geopolitical risk and a lack of monetary intervention.

Even though the lira continues to carve fresh all-time lows on what seems a daily basis, progress has been made in an attempt to stop the haemorrhaging. Last week, the central bank (TCMB) opted to raise interest rates by 200 basis points, with the signal of an interest rate hike more important for markets than the actual hike itself. While 200bps is nothing to be frowned at, the fact that the TCMB is opting to hike interest rates as opposed to continuing its policy of tightening monetary policy in a stealthy manner should start to slow the pace of TRY depreciation, especially if the signals for further aggressive hikes are forthcoming.

Since early August, the TCMB has refrained from officially hiking interest rates, opting to manage liquidity in markets instead. By doing so, offshore liquidity in the lira has been squeezed on multiple occasions, shaking speculative short-sellers out of the market.

While in onshore markets, domestic banks have been siphoned away from the one-week repo rate and into more costly interest rate windows in order to curb inflationary pressures that are rumbling away in the Turkish economy. However, despite the average cost of bank funding rising in response to the liquidity shortage, FX markets were yet to feel the effects of higher domestic interest rates. With the lira continuing to crack fresh lows and speeding towards the 8.00 level, the TCMB’s hand was ultimately forced and interest rates were officially increased despite the political sensitivity of the move. FX markets responded accordingly to the news, with the lira posting its first day of gains in two working weeks on Thursday. However, normal service resumed in the subsequent trading sessions, with USDTRY climbing 2.9% since interest rates were hiked as investors questioned whether the monetary policy decision was the start of a new hiking cycle akin to that seen in 2108 or a case of one and done.

The fact that the lira continues to sell-off in an aggressive manner suggests that it may ultimately be the former of the two scenarios, even if the central bank intended otherwise only last week.

However, with the TCMB introducing liquidity back into the one-week repo window, the cheapest source of short-term funding for domestic banks, another aggressive interest rate hike may not necessarily be forthcoming as future tweaks may be undertaken in a similar stealth manner as seen in August. Now USDTRY has broken through our Q3 target of 7.5 and achieved our Q4 forecast of 7.8, the natural question is where the ceiling is for the currency pair. This isn’t an easy question to answer as it depends on the trade-off between higher interest rates and a weaker currency – both of which are politically sensitive. For markets, an answer to the aforementioned question over the TCMB’s future plan for interest rates is likely to be answered in a matter of days, especially as USDTRY approaches the 8.00 level at a rate of knots. Once the central bank’s reaction to the 8.00 level being tested is observed, markets will be dealt a clearer picture of the future path for TRY and interest rates.

 

TCMB delivers a 200bp rate hike to reset the interest rate channel higher, but is this the start of more stealth tightening or an aggressive interest rate cycle?

 

USDTRY hurtles towards the 8.00 level with no signs of emergency intervention forthcoming

 

Author: Simon Harvey, FX Market Analyst
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