Turkish central bank loses credibility as lira decline continues

The Turkish lira has fallen sharply on Tuesday after the central bank failed to raise interest rates as expected. The market had expected to see a 50 basis point rise in the benchmark repurchase rate, however the central bank decided to keep rates on hold at 8%. The overnight lending rate was raised by 75 basis points, as expected, while the overnight borrowing rate was not increased, dashing expectations for a 25 basis point rise.

Overall, this is a disappointing move, as the central bank did the bear minimum to try and halt the decline in the lira. The central bank said that it would hike interest rates further, but only if the inflation outlook deteriorated. This could be a self-fulfilling prophecy, as today’s drop in the lira is likely to heap further upwards pressure on Turkey’s CPI rate, which climbed to 8.53% in December.

It’s the politics, stupid…

Overall, today’s decision is likely to be viewed by the market as a politically motivated, rather than an economic one. The Finance Minister and President Erdogan have both said they don’t want to see higher interest rates due to the damage that it could do to the economy. We will have to wait for the 2016 GDP report, due in March, before we see to what extent the weaker lira is weighing on economic growth, and however, the future trajectory for the lira does not look good.

When the independence of a central bank is threatened, as is the case in Turkey, the market’s trust is lost, which can weigh on a currency, as we are seeing today. However, Turkey has multiple issues, not least a lame duck central bank. Terrorism and the upcoming Constitutional Referendum are all likely to keep downward pressure on the lira in the near term.

Constitutional Referendum likely to keep the lira under pressure

We believe that the Constitutional Referendum is another key risk event for the lira. It is scheduled to take place on 2^nd April, and if the government wins it would essentially extend President Erdogan’s already considerable powers, giving him executive Presidential status, and essentially eroding Turkey’s democracy.

A rocky road for USDTRY, but why we expect further record lows in the lira

Although we do not rule out USD/TRY rising to above 4 in the next few months on the back of Turkish political risk, we note that USD/TRY upside could be limited by any weakness in the dollar on the back of political risk in the US. Thus, we expect to see even more heightened levels of volatility in this pair in the weeks to come. This pair is not for the faint hearted.

On balance, we expect to see only limited rallies in the lira, and further downside. The only thing that could halt the Lira’s demise at this stage would be a significant rate increase from the central bank, of, say, 5% or more in one go, or the political demise of President Erdogan, who has been a negative influence on the currency since last year’s attempted coup.