The risk is they do nothing on political pressure, which would be very bearish Turkish assets. I think that they will have to hike before the elections one way or another.
That’s from Quaestio Capital Management’s Lorenzo Gallenga who spoke to Bloomberg for a piece that details analyst angst regarding the upcoming rate decision from CBT.
This is one of the more intriguing EM sagas in recent memory coming as it does just weeks ahead of a historic “election” that will invariably consolidate power in the office of President Recep Tayyip Erdogan. “Election” is in scare quotes because this isn’t an “election” in any real sense (go back and trace the evolution of domestic politics after the 2015 elections in Turkey for a window into Erdogan’s thinking when it comes to unfavorable outcomes). Simply put: he’s not going to tolerate a disappointment.
The run on the Turkish lira isn’t just a reflection of Erdogan’s penchant for pushing conspiracy theories about nefarious “interest rate lobbies”, nor is it merely a product of his unorthodox views on the relationship between rates, FX and inflation.
There are underlying fundamental problems and when it comes to EM, the wobbliest dominos get tipped first in the event an exogenous shock from Fed tightening comes down the pike. This time around, Turkey and Argentina were the wobbliest dominos.
CBT backed themselves into a corner last week by suggesting they’d hike again if Monday’s inflation data warranted more tightening. And of course the data painted a rather grim picture, with core accelerating further:
For those who need a refresher on recent developments in the context of that print and this week’s policy meeting, you can check out “Everything Should Be Fine ‘After The Election’: Inflation Surges In Turkey, All Eyes On More Hikes“.
The Bloomberg piece linked above has a summary of analyst opinions and while you can argue about what they will do, there’s little question about what they should do – they need to keep hiking until they “shock and awe” the market into backing off the speculation.
Of course that’s a tough sell with Erdogan whose insane Bloomberg interview last month was the last straw for a lot of folks who were still giving CBT the benefit of the doubt.
Meanwhile, Argentina is closing in on cementing a $40 billion IMF credit line and according to Morgan Stanley’s estimates, the country has a 67% chance of securing EM status. The ETF has bounced smartly on renewed optimism after hitting a nine month low:
The central bank has obviously gone to great lengths to stabilize the peso after a truly harrowing couple of weeks that necessitated a series of draconian hikes, culminating in a push to essentially hold the line at 25.
Well with the CBT on deck and questions still swirling around Argentina, it’s worth taking a look at the history of FX depreciation to determine when “enough is enough”, so to speak. That’s just what Goldman has done in a new note.
While the bank has previously explained that what you’ve seen recently in Argentina and Turkey is primarily the result of the exogenous shock from a stronger dollar, rising U.S. rates and a Fed that’s predisposed to sticking to its guns in light of ongoing strength in the U.S. economy and the prospect of late-cycle fiscal stimulus triggering an overheat, the bank does think there’s something to be gleaned from “benchmark[ing] the selloffs in Turkey and Argentina to similar historical episodes” which Goldman defines as “devaluations of 10% or more that appear to be idiosyncratic in nature, i.e. not during events like the Global Financial Crisis.”
Their first takeaway is as follows:
EM/FM FX selloffs tend to be fully recovered over time (if often takes about 1 year for EM currencies and 16 months for FM currencies after the initial devaluation to recoup the initial loss from the selloff). It is important to note that this recovery is on a total return basis, and that most of the return is coming from carry. One should not expect ‘spot’ levels of FX to recover even after two years.
The more interesting bit comes when Goldman differentiates between “heavy” hikers and “light” hikers in the context of central bank intervention to stop currency depreciation. Here’s how they break this down:
We look at eight major, idiosyncratic EM selloffs and separate the episodes into those during which the central bank hiked the most aggressively (ZAR December 2001, BRL June 2002, TRY May 2006, RUB November 2014) and least aggressively (IDR April 2001, PLN May 2010, ZAR May 2013, BRL March 2015). On average the “heavy hikers” raised rates by 50% over the 6 months following the selloff, while “light hikers” only increased rates by an average of 5%.
Unsurprisingly, “heavy” hikes work better when it comes to engineering an FX recovery. Specifically, Goldman notes that “in total return terms ‘heavy hikers’ see a 32% return on average after 24 months, while ‘light hikers’ see an average return of 8%.”
So where do Turkey and Argentina fit into that framework? Well, if you look at the evolution of policy in both countries and compare it to the average “heavy hiker” path, it turns out that Argentina is right on course, while Turkey has some room to go:
This again suggests CBT is still behind the curve and I’m reasonably sure Goldman didn’t include a variable to account for “lunatic autocrat who calls interest rates ‘the mother and father of all evil'” in their models.
So we’ll see what happens with CBT, but do note that this is no trivial/esoteric/academic debate. These two countries represent the first cracks in an EM complex that many believe is ill-prepared to digest Fed hikes that actually tighten financial conditions (as opposed to what we’ve seen during this cycle thus far, which is an ongoing loosening of conditions despite Fed hikes thanks to the weaker dollar and still low long rates in the U.S. during 2017).
