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The surprisingly dovish announcement by the Fed last week provided the Turkish lira with some much needed respite. That said, and in line with our expectations, the rally quickly faded, and we anticipate the lira will remain one of the main EM underperformers into year-end as investors become more selective in their asset allocations. Today's press conference by Governor Basci fuelled further weakness in the lira, as the market did not receive the hawkish commentary it was looking for. With interest rate hikes seemingly off the table for now, and policy divergence between the CBRT and other emerging market central banks becoming even more apparent, we anticipate the USDTRY cross will drift higher into year-end, towards the 2.10 level. The next focus for the market will now be the Democratisation package to be announced on Monday, in which minority groups hope to receive some of their much awaited reforms. If not, this could spark an escalation in protests, although this is not our base case scenario.
US Fed provided the lira and therefore the CBRT with some breathing space. Since tapering talk began to weigh on markets' minds in mid-May, the lira has been one of the most under pressure currencies, given Turkey's huge external financing requirement. In this bleak environment for emerging market assets, central banks were put under significant pressure to act, and try and defend their currencies. This led the likes of India, Brazil and Indonesia to take significant policy action including benchmark interest rate hikes to take pressure off their currencies. Meanwhile, Turkey's central bank remained resilient, with small hikes in the upper end of the interest rate corridor, coupled with continued FX reserve depletion. Although such moves had a limited impact on the lira, Governor Basci and the CBRT has remained defiant in its stance commenting that the lira is not vulnerable and also that the market has overreacted to Fed tapering concerns, with portfolio inflows soon to return to Turkey. The dovish decision at last week's FOMC meeting does support Governor Basci's view although we think this is short term.
Lira respite did not last for long. The decision by the Fed to delay tapering was a big relief for the CBRT, given significant pressure on the lira over the past few months. That said, and although tapering is yet to begin, we highlighted in CEEMEA Top View | Looking past FOMC our opinion that investors are now becoming a lot more selective in their asset allocation. We note that outflows from EM Fixed Income over the last three months cover just 14% of total inflows into local currency bond funds since January 2009 and therefore positioning wise, we see room for more outflows, with investors likely to cautiously move money away from large twin deficit countries. For example in the CEEMEA region, we view currencies of economies with better fundamentals (RUB, PLN, HUF, ILS) outperforming in the remainder of the year, while countries that continue to suffer structurally TRY and ZAR will remain under pressure. Hence we suggested fading any significant rally in Turkish and South African fixed income assets, a recommendation that appears to be playing out.
EM central bank policy divergence will bring the lira back under pressure. Although Turkey's growth rate will likely be the outperformer in the CEEMEA region in 2013, this is not the focus for investors Turkey's vulnerabilities are (Turkey | Growth is strong, rebalancing is not). One of our main concerns is the divergence in central bank policy for those currencies under pressure. For example, we highlight recent proactive steps including interest rate hikes taken by Brazil (Brazil | Expected +50bp and BRL) and Indian (India | RBI relents on INR support measures, tighter on inflation) central banks in a bid to defend their currencies. This is in contrast to Turkey, where the central bank remains reluctant to take the necessary measures to support the currency. Given Turkey's scarce number of FX reserves, hiking rates is the necessary step, as we have long argued. In particular, many investors we talk to are waiting for real yields in Turkey to catch up to those in Brazil for example. With inflation likely to remain elevated, this would require ~400bps worth of higher real rates in Turkey, highlighting the need for rates to rise significantly to attract portfolio inflows. We therefore currently see TRY in a similar camp to ZAR, in which we also find the central bank retaining its accommodative monetary policy stance (see South Africa | SARB in no rush to hike).
CBRT reluctance to hike rates continues. We have commented on several occasions previously the need for the CBRT to become more orthodox in its policy response during periods of outflows. Investors are looking for interest rate hikes and less FX reserve depletion at this current time. However, the Governor's speech today did not provide us with much comfort on this front. Although Basci commented that the current policy position is tighter that in the past, and that we should not expect interest rate cuts in the near term, this is as hawkish as his commentary got. Basci was also cited as saying that the central bank has done more than is necessary already and has no plans to tighten policy further. In addition, the Governor continued to discuss the use of FX reserves to smooth volatility and therefore reserve depletion is likely to continue. Interestingly, Governor Basci also said that the central bank's hands are not tied. This is clearly in response to the view that the government is forcing the CBRT to keep interest rates low in a bid to support growth ahead of elections.
Inflation will miss the CBRT target no surprise here. Governor Basci for the second time in recent weeks backtracked on his previous lira prediction of a 1.92 USDTRY level by year-end, indicating that this stemmed from the bank's year-end inflation assumption of 6.2%. On this front, Basci said that inflation will continue to decline in the coming period, although also noted that inflation will remain a bit above the 6.2% year-end target. Governor Basci also said that any danger to the 24-month inflation outlook may mean extra tightening, adding that short-term rates would be raised if necessary on the inflation outlook. Comments herein follow recent MPC minutes, which indicate that the committee will implement additional monetary tightening at the appropriate frequency until the medium-term inflation outlook is in line with the medium-term targets. Our view remains that the CBRT is comfortable with current inflation levels, and at this time would prefer to focus on its other targets, including growth. For example, clearly there are significant risks to the central bank's inflation forecast, given that it is based on USDTRY at 1.92 by year-end, while the cross is currently trading at around 2.0, and we predict this will drift even higher by the end of the year. Therefore with a high FX pass through to inflation of ~23%, we retain our year-end inflation forecast of 7.8% and think that the CBRT should already be hiking policy rates if it was committed to meeting its inflation forecast of 6.2%, let alone the target of 5.0%.
Governor Basci does not appear concerned with the lira recent depreciation is natural in his view. In line with what we have seen at previous press conferences, Governor Basci tried to calm the market and indicate that things are under control. Looking at his comments on the lira in particular, Basci seemed comfortable with recent lira price action. For example, he said that the correction of the lira REER to below 110 is realistic, that there is no need to be alarmist at this point, where lira depreciation since May 22nd is natural. His confidence in the lira strengthening from here was also apparent in his comments that Turkish firms should not be worried about the lira value and that the market has already priced in Fed tapering. Overall we think these comments confirm the recent view of the CBRT, which does not seem to mind some lira weakness, as long as it is in line with a broader emerging market FX sell off. For this reason, we think it will require a significant sell off in the currency, beyond the 2.10 level, before the central bank is forced to act and hike rates.
All eyes now turn to the Democratisation package. The eagerly awaited Democratisation package is expected to be announced by Prime Minister Erdogan on Monday 30th September. The details of this package will be important, as we will find out whether the Kurds, Alevites and possibly the journalists are getting the reforms and increasing rights that they are after. Expectations are for the government to provide some reforms for these groups, given that Prime Minister Edogan recently said that "When the package is announced, every sector of society will be happy". Some of the announcements in the package that minority groups are looking for include Kurdish education in private schools, Alevite temples being granted charitable foundation status and a possible lowering of the election hurdle from the current 10%.
Minority groups being satisfied with the reforms is important to keep them from joining the protests in significant numbers. Following our trip to Turkey earlier this year, we commented that protests which are ongoing in the background will only intensify and have asset class implications if the Kurds and Alevites joined the main protests in significant numbers against the AKP, which was not our base case scenario and still is not. In particular, we note that these groups realise the AKP provides them with the most likely chance of reform. Our local sources indicate that the Kurds are not expecting too much from the upcoming reform package, and hence their expectations are quite low. They understand that the government cannot provide too many reforms to minority groups ahead of local elections in March of next year, and will therefore instead likely push for further reforms after elections. Overall however, we think it is crucial that the government provides the Kurds in particular with some concessions for example Kurdish education in private schools to ease tensions at a time when the Peace Process has clearly stalled.
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