23 July, 2018
Further increases in US interest rates are likely to maintain underlying downward pressure on the lira. The currency will also be vulnerable on domestic political concerns and regional security fears while high inflation will erode medium-term value. High interest rates will certainly provide relief at times and seasonal capital inflows are liable to provide support during the summer months.
Overall, there is some short-term value in buying the currency for commercial and holiday requirements with USD/TRY liable to retreat to below 4.50, which is somewhat feasible considering current rates is 4.52, but depreciation is likely to resume from late in the third quarter.
The Turkish lira has been under sustained pressure during 2018 with a loss of 20% against the US dollar with the currency undermined by a combination of domestic and international factors. USD/TRY exchange rate strengthened to a peak above 4.90 in May from 3.79 at the beginning of the year before a corrective retreat to near 4.60. EUR/TRY also strengthened to highs above 5.70 from 4.55 despite underlying Euro losses (with current rate of 5.33).
The central bank has increased interest rates to stem losses. The one-week repo rate will now be the main policy rate and has been increased to 16.5%, and then again to 18.0%.
Domestic price pressures have increased this year with the annual consumer inflation rate increasing to 12.2% for May from 10.9% previously with producer prices increasing 20.2% over the year.
When inflation rates are relatively low, data showing a faster pace of interest rate increases tends to strengthen currencies on expectations of central bank policy tightening. High inflation levels, however, are a key source of medium-term currency vulnerability as purchasing power is eroded. Over the longer term, sustained inflation rates above the OECD average will inevitably weaken a currency. Unless Turkey can reduce the underlying inflation rate, the lira will inevitably weaken against major currencies over the medium term.
The Turkish PMI manufacturing index declined to 46.4 for May from 48.4 the previous month, reinforcing a lack of confidence within manufacturing and wider vulnerability surrounding growth. Weak growth will continue to sap underlying investor support, especially with damage from higher oil prices. Ratings agency Fitch has put the credit rating of Turkish banks under review and Moody’s has put the sovereign rating on watch for a potential downgrade due to concerns over economic management.
An important element in currency determination is global investor confidence, especially as Turkey runs a current account surplus. A key element in sustaining investor confidence is central bank independence for monetary policy and set interest rates, especially as this is crucial in controlling inflation.
Although the government remains notionally committed to central bank independence, there have been repeated warnings from President Erdogan over the threat posed by interest rates and need to lower borrowing costs in order to protect growth.
Political uncertainty will be an important short-term element with Presidential and parliamentary elections that took place on June 24th. There were strong expectations that President Erdogan will secure another term in office, although there were significant doubts whether his AKP party will secure a parliamentary majority. He has won the elections with ease, but it did not sooth the markets as much as another candidate would, especially as Erdogan has pledged to replace the current parliamentary system with an executive presidency.
US Federal Reserve policy has been a crucial element over the past year and will continue to play a very important role over the next few months. The Fed has increased interest rates steadily with the Fed Funds rate currently in a 1.50-1.75% range following the latest increase in March, and then raising again 1.75%-2.00% with expectations of 4 hikes this year.
Higher US interest rates tend to strengthen the dollar, especially against vulnerable and emerging-market currencies. Dollar borrowing by international companies is crucial in this process. If companies outside the dollar area borrow in the US currency, the cost of interest payments will increase when interest rates increase. This will directly increase borrowing costs and the impact will be amplified if the dollar strengthens in global currency markets.
In this environment, higher US interest rates are important in tending to undermine emerging-market currencies such as the Turkish lira.
If the Federal Reserve continues to raise interest rates over the next few months, underlying pressure on the lira is likely to increase, especially with wider losses in emerging markets also having a negative impact on the lira.
US President Trump has adopted a tougher stance on Iran, pulling the US out of the nuclear accord. There has been hawkish rhetoric on Iran and equally tough responses from the Iranian regime. The Syrian situation is also continuing to simmer after the US launched air strikes following allegations that the regime had used chemical weapons.
Given that Turkey has a border with Iran and Syria, there will be concerns that any increase in regional tensions will pose a threat to the Turkish economy, especially as there would be the risk of further upward pressure on oil prices.
Tourism revenue continues to play a very important role in the Turkish economy and will have a key impact on the currency through the current account balance.
On seasonal grounds, there will be a strong boost to tourism earnings in the short term with a jump in visitor arrivals during the summer months. These flows will provide important support to the current account and will lessen the threat of aggressive lira selling in the short term.
Revenue will, however, fade again from late in the third quarter and this will tend to increase underlying vulnerability once again as the balance of payments situation deteriorates.
Given that domestic interest rates are extremely high, there is a high cost of carry involved in any speculative lira selling by hedge funds. A corrective lira recovery could, therefore, gather pace quickly as international funds would liquidate short lira positions quickly to stem losses.
In this context, high volatility is likely to be key feature over the next few months.
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