We expect the CBT to end the tightening cycle and remain on hold this month with inflation peaking, relief in domestic political concerns and the conducive external backdrop. Equally, the bank is likely to refrain from early easing. This should be TRY supportive as the lira retains its very high risk adjusted carry. TURKGBs look attractive from a carry perspective, but one should not expect a YTD-like strong performance as the CBT is at no hurry to cut rates.
• The CBT is to keep the current tight liquidity stance for a while, until the recovery in the inflation outlook becomes apparent.
• Ongoing geopolitical issues (which could create pressure in market prices) as well as still elevated inflation levels will likely force the CBT to be cautious and refrain from early easing.
• We think any easing would be via gradual increase in TRY liquidity, while the policy rate, the upper/lower bounds of the interest corridor and late liquidity window rate will likely remain unchanged until the year end.
FX: In the current carry-friendly environment, TRY continues to stand out for numerous reasons: (a) the CBT regaining inflation-targeting credibility by keeping interest rates high despite CPI likely reaching its peak and the appreciating TRY; (b) TRY offers extremely attractive risk adjusted carry compared to its high yielding EM peers (Fig 5) due to the CBT’s tight liquidity stance and high average funding costs; (c) the still very attractive medium-term valuation, with USD/TRY currently being overvalued by c.24%. The expected CBT decision on Thursday to keep interest rates unchanged and leave the current liquidity stance tight (now and for a foreseeable future) should underpin the lira’s attractiveness. In the relative value space, TRY seems to be the most attractive among the CEEMEA higher yields as RUB decoupled from the oil price and seems too rich while ZAR’s highly unpredictable domestic politics warrants a larger risk premium and caution vs TRY. We expect USD/TRY to break through the 3.5000 level, though the bulk of future returns from long lira positions should come from the carry factor, rather than spot appreciation.
Domestic Debt and Rates: Following a c.150bp rally in long-end bond yields from the peak observed at the beginning of this year, we do not expect further strong performance. The 10-year TURKGB yield should not meaningfully break below the 10% level given the tight CBT policy stance and what we see as a low probability of rate cuts in coming months. Yet, given its high nominal yield and the likely increase in real yields once Turkish CPI starts moving lower more meaningfully (by the end of this year or the beginning of the next – Fig 6), TURKGBs look attractive from a carry perspective. Long dated bond yields should hover around current levels in coming weeks. For USD-TRY cross currency swap rates, we also expect limited room for a decline from here, given the tight CBT liquidity stance and expected only modest TRY spot appreciation.
In the June MPC meeting on 15 June, we expect the Central Bank of Turkey (CBT) to remain mute and keep all relevant rates unchanged. Since the beginning of this year, the CBT has increasingly used unorthodox policy tools and in the last two meetings, the bank was more hawkish than expected with more-than-expected hikes on the late liquidity window rate. The bank has pulled the effective cost of funding significantly up, by c.370bp since end-2016, to close to 12.0%. During the tightening process, the late liquidity window (LLW) rate, a facility to cover emergency needs of the banks, has been aggressively utilized, while the bank has also introduced a new tool by opening an FX-deposits-against-TRY-deposits market, a swap facility with 1-week maturity. Utilisation of the tool has reduced volatility in excess TRY liquidity in offshore markets and helped achieve stabilisation in the TRY. This month, we do not expect a further tightening move, given that inflation has already peaked in April.
Following significant deterioration in recent months with the lagged spillovers of TRY depreciation and volatility in food prices, inflation showed modest improvement in May from its high levels in April (the highest since the GFC). Core inflation (excluding all food & beverages, energy, alcoholic drinks & tobacco, gold) recorded a 1.33% change, below the average of May changes. This is another sign of weakening following a moderation in the strong upward pressure last month. As a result, annual inflation in this indicator inched down to 9.38% from 9.42% a month ago. However, core figures stay elevated, despite the fading FX pass-through. We thus think the bank has likely reached the end of the tightening cycle and won’t embark on further tightening unless the currently supportive global backdrop changes significantly. Recent TRY strength (due in part to the supportive global backdrop and improving political climate after the referendum) works to the CBT’s advantage, with increasing downside risks to the inflation outlook.
On the flipside, the bank should refrain from early easing and keep its current tight liquidity stance in place for a while, until the recovery in the inflation outlook becomes apparent. Economic activity continues to strengthen, thanks to fiscal easing, given stimulus measures such as VAT cuts in some consumer durables and social security premium cuts and significant lending acceleration. Credit growth (13-week MA, FXadjusted and annualised) has converged to 25% on the back of contributions from the Guarantee Fund. Recently released indicators hint at some further acceleration in 2Q17 economic activity, with higher PMI in tandem with rising CUR.