Pressure Builds On TRY

The Turkish Lira (TRY) has been one of the worst-performing Emerging Market currencies over the last several months, even underperforming the Mexican Peso. Given the level of the decline, the market is increasingly expecting the Central Bank of the Republic of Turkey (CBRT) to take action, leading to a potential reversal in TRY direction. While there are risks to a recovery linked to domestic politics, possible ratings agency actions and the external environment, on the key issue of central bank policy it seems that things are starting to change.

The CBRT’s policy response has been accelerating recently and reflects an increased willingness by the CBRT to take more affirmative and creative action to deal with TRY volatility. If the CBRT delivers a rate hike across all policy rates next week and continues their willingness to use the late liquidity window, then TRY could trade better.

Below are a few factors that are necessary for the TRY to start trading better.

More aggressive use of FX swap facility

The FX swap facility can be a sharply effective tool for lifting the cost of shorting/borrowing TRY through FX forwards. This tool has some clear benefits as the CBRT can push the yields on USD/TRY FX forwards to punitively elevated levels in response to pressure on the currency and then reduce them when the pressure dissipates.

This gives the CBRT similar flexibility to the unorthodox “corridor” mechanism through which the CBRT controlled borrowing rates for the banking sector until the recent “simplification process” was finalized. However, the rate on the TRY component of the swap needs to be meaningfully increased.

At the first and second auctions the CBRT offered only 8% and 8.5% respectively with a UD rate of 0.7% and 0.75%. It is possible that the CBRT was only testing the system before applying it more aggressively. As it stands, the swap facility by itself is not enough to spark a TRY rally but it does offer a tool through which the CBRT can address market speculation, particularly by foreigners in the FX forward market which, from recent statements, it appears the government believes is the primary reason for currency weakness.

Maintaining the corridor

Over the past week, the CBRT has aggressively used the late liquidity window to raise the blended cost of funding by around 0.75% to just over 9%, having increased by 1.25% since mid-November. There is scope to raise the blended cost of funding further and if the CBRT do hike all policy rates next week then they will have the option to raise the overall cost of funding even more.

This is important and if the CBRT do use this facility then it would be a good omen. By effectively shifting the upper band from the CBRT’s overnight lending rate to the late liquidity window flexibility has been restored.

Through raising rates in this way, the policy approach would complement the aims of the FX swap facility making it more likely that other rates in the economy will rise, such as local currency deposit rates. The subdued level of TRY deposit rates has been a contributing factor behind the switch from locals into FX.

Rate hikes are necessary

At this stage, the CBRT needs to hike across all policy rates to address the severe decline in inflation expectations, with CPI likely to head close to double digits over coming months. A hike in the main policy rates as well as an increase in the late liquidity window, combined with hawkish guidance, should be enough to provide a floor for TRY.

However, given the CBRT’s track record, it is unlikely that higher rates and tighter policy will be maintained for long but the important thing is that the CBRT demonstrates its willingness to act and support the currency which means that the level of support should increase if market pressures build. As the market understands this more it will become an important shift in the market dynamic.

The need for the central bank to act decisively is growing in urgency. Turkey’s current account deficit is wide and widening, the geopolitical situation is extremely precarious and there is a forthcoming referendum which, if successful, would overhaul the political system in significant way, potentially creating more uncertainty down the road.

With growth slowing and fundamentals worsening, at a time when the Fed is likely to continue raising rates, suggests that any rally in TRY is likely to be short-lived and fresh lows will be printed over the year.

Technical Perspective

If the CBRT do deliver a meaningful monetary policy adjustment next week and TRY is able to rally, then the next key support within the USDTRY bull trend will be the 3.5951 area.