On Tuesday, the financial news media is awash with stories documenting the collapse of Turkish assets in the face of the ongoing diplomatic spat between Washington and Ankara.
This is hardly the first time the U.S. and Turkey have been at odds over President Recep Tayyip Erdogan’s penchant for arresting people on trumped up charges of conspiring against his government, but the current row comes at a particularly sensitive time. The market has been on pins and needles since July 9, when Erdogan placed his son-in-law in charge of the economy. That decision removed any doubt about whether Erdogan was serious when, in a May 15 interview with Bloomberg Television, he explicitly indicated his intention to take a more hands on approach to monetary policy following the election on June 24.
Back in April, when it looked like things might start to go off the rails for the Turkish lira, Erdogan decided to bring forward a landmark election designed to consolidate power in a new executive presidency by more than 18 months. Initially, market participants interpreted that as somehow bullish for Turkish assets (the excuse was that it would remove uncertainty). It wasn’t bullish – not at all. In fact, what it effectively meant was that Erdogan would be consolidating power 18 months sooner than expected, because the results of the “election” (scare quotes there for a reason) were never really in doubt.
Soon enough, the currency was under pressure again and on April 25, the central bank delivered a 75bp hike to the late liquidity window. “I could be wrong, but I don’t think this is going to be sufficient”, reads the first line of my post from that day.
Well it wasn’t – sufficient, that is. Within a month, Turkey had the beginnings of a currency crisis on its hands. Erdogan’s deadpan interview with Bloomberg made things immeasurably worse and by May 21, at least one Istanbul-based broker was appealing to God for help.
But in Turkey, Erdogan is God, and God has famously described himself as “the enemy of interest rates”, which meant that anyone who was still hoping that CBT would deliver the medicine when it came to arresting the slide in the currency was bound to be disappointed.
On May 23, amid what at the time counted as a harrowing slide in the currency (the bar for defining lira weakness as “harrowing” has since been raised) Erdogan let the central bank try an emergency hike to the late liquidity window. Five days later, CBT simplified the monetary policy framework and on June 7, hiked the one-week repo rate. That hike was met with cheers from the market and a veritable chorus of commentary about the extent to which the central bank had successfully proven its independence on the way to regaining control of the lira.
That, frankly, was an absurd contention to make (and I’m not tilting at windmills here, I can cite you specific examples of people who said that, or something close to it). The central bank backed themselves into a corner ahead of that hike. If you go back and look at what officials said in the days ahead of the decision, they explicitly promised to act in the event the inflation data warranted it and that inflation data was due three days prior to the meeting. If you’ve been following along, you know the inflation backdrop has worsened materially in Turkey, so there was no question as to whether the data would warrant a hike. I’m not sure why they talked themselves into that corner given Erdogan’s absurd penchant for blaming higher inflation on higher rates, but they did.
Here’s what I said on June 7, minutes after the hike and amid a knee-jerk surge in the lira:
I don’t know how long it’s going to take for everyone to come to terms with the fact that exactly none of this is done without Erdogan’s consent and that that consent is predicated not on concerns for CBT credibility, but rather out of concern for political expediency, but what I do know with absolute certainty is that as soon as he feels like the run on the lira is over, things will go right back to the way they were and he’ll go right back to shrieking about lower rates in public speeches. Buyer beware.
For good measure, I tweeted this:
— Heisenberg Report (@heisenbergrpt) June 7, 2018
Fast forward one month (almost to the day) and Erdogan was busy making the economy a family business by effectively replacing Mehmet Simsek with Berat Albayrak. Do you know what else Erdogan did? Well, I’ll tell you: he amended the central bank articles of association to give himself more sway over monetary policy, that’s what he did.
Having learned absolutely nothing from all of the above, the market (and by that I mean consensus) was still looking for a rate hike from the central bank on July 24, a notion I explicitly lampooned as something that bordered on insanity. Erdogan’s intentions were as clear as they could be and sure enough, CBT didn’t budge, leading to a fresh leg lower for the lira.
Here’s a full, annotated chart that traces the evolution of this:
(Major events impacting Turkish lira since March)
That’s what happened in three months prior to the Andrew Craig Brunson drama. On July 26, when it was clear that Erdogan was angling to try and use Brunson as a pawn to secure the extradition of Fethullah Gulen, I published a lengthy post on the politics behind the Brunson dispute and at the tail end of it, I said this:
For traders and, perhaps more importantly, for asset managers, this is just further evidence that Turkish assets are anything but attractive following last month’s election. While EM fund managers will claim to understand all of this, it still feels like there’s a generalized unwillingness to accept the reality of this situation.
Accepting idiosyncratic, country-specific risk is part and parcel of investing in emerging markets, but this has gone well beyond that. This is Erdogan—specific risk and he has shown time and again that betting on him to abruptly step out of character and demonstrate some semblance of rationality is fool’s errand.
Fast forward to Tuesday and things have fallen completely apart. Since that July 26 post, I’ve variously documented further evidence of Erdogan’s belligerence, suggested that Halkbank was about to get hit and warned that Turkish bonds were likely to get crushed. All of that has played out.
(Shares of the New York-traded iShares MSCI Turkey ETF have been crushed; the vehicle got $6.5 million in inflows on Monday as some folks bought the dip)
Here’s what BofAML had to say on Monday as 10Y yields in Turkey neared 20% and the bottom fell out in earnest for the currency:
Catching a falling knife. We maintain a cautious stance on Turkish assets. The strong weakening YTD makes carry attractive in an EM context, but we do expect the deterioration trend in macro fundamentals and geopolitical noise to continue. As such, we don’t think the market will be driven by mean-reverting behavior in a similar way to some other high-yielding EM. In TRY, current account deterioration has accompanied currency weakness. High inflation means rates are not cheap despite nominal widening. FX weakness will keep sovereign credit wide despite attractive levels vs. rating peers.
In a testament to how wild this situation truly is, the American embassy in Turkey on Tuesday was forced to refute a Turkish media report that U.S. officials are calling for the lira to plunge to 7.00. “It is unfortunate and disturbing [and] is completely unfounded”, the embassy said, in a tweet, before accusing Turkish media of being “irresponsible”.
(An escalation ladder, via Barclays)
Remember, it’s not so much the effect of the sanctions on two ministers that matters here. Rather, it’s the effect those sanctions could have on sentiment that counts when it comes to Turkey, given its reliance on external funding.
“While Europe is the dominant source of private sector financing and banking sector exposure, the deterioration in US-Turkish relations can significantly influence the country’s access to global capital markets”, Barclays warned, in a note dated August 3. They continued:
We previously emphasized the relevance of Turkey’s relations with the West for investor confidence. In fact, any long-lasting deterioration in relations with the West, particularly the US, could negatively affect investors’ willingness to meet the country’s financing needs, exposing roll-over risks.
(Turkey, 10-year yield, Bloomberg)
As far as what comes next, I would suggest (again), that Erdogan may be more inclined to make a deal for Brunson than he is to countenance an emergency rate hike large enough to shock and awe the market into laying off the lira. A Turkish delegation is set to arrive in Washington on Tuesday and hold talks with the U.S. on Wednesday in an apparent effort to resolve the dispute.
“Publicly, Turkey will have to appear to be self-righteously indignant, and to retaliate, [but] privately, we believe negotiations on Pastor Brunson’s release continue apace,” SocGen’s Phoenix Kalen wrote last week, before suggesting that Trump will first have to convince Erdogan the U.S. is serious about imposing the kind of sanctions that could plunge Turkey into an economic crisis before negotiations on Brunson will move ahead in earnest.
“Until the threshold of pain is reached that convinces Turkey to resolve the diplomatic impasse, then there will likely be further TRY depreciation and upward pressure on Turkish rates / bond yields, in our opinion”, Kalen continued, adding that “the dissolution of Turkey’s monetary policy anchor in the face of mounting inflationary pressures exacerbates the situation, adding to deteriorating macro-dynamics in Turkey.”
Ultimately, you can draw your own conclusions from the above, but if Erdogan doesn’t do something fast, he’s going to find himself in the extremely awkward position of having to look for some kind of bailout package less than two months into his new role as pseudo-Sultan. Either that or resort to a series of dramatic rate hikes (anathema to the President).
Oh, there’s one other option: draconian capital controls.
