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ANALYSIS: The Fed and the Turkish Lira

Any bout of depreciation that seems possible is likely to get tangible starting from 2Q19. Thus, lira is likely to stay immune from today’s Fed’s rate hike and the possible fourth hike in December. Then as the Fed is expected to start signaling an end of its rate hike cycle beyond 2019 and emerging market currencies start stabilizing; whether lira would remain on the depreciation path in the later months of 2019 will all be in the hands of the AKP government’s performance on balancing and reforming the Turkish economy along with dealing the pressures of external debt payments and its effects on the banking sector; in terms of funds needed to keep the economy functioning.

ANALYSIS: The Fed and the Turkish Lira

Nothing unexpected happened; yet, there was a profound change.

The Federal Reserve (Fed) on Wednesday raised its key interest rate by 25 basis points to a range of 2%-2.25%; the third time this year and signaled one more, likely in December.  To recall, this was the eighth time the Federal Open Market Committee (FOMC) raised borrowing costs since it started in December-2015 after keeping the rates near zero to speed up the economic recovery following the Great Recession.

During when the Turkish lira along with many emerging market currencies were engaged on a path of depreciation following long years of easy money spurring growth at the cost of elevated value of the same batch.

In Wednesday’s rate decision the Fed also announced it ended “accommodative” monetary policy marking the end of an era.  Such a switch to “positive real rates” will no doubt have a greater impact on the emerging market currencies that have been plummeting since the start of the year as the bank was expected to reach the final rounds in its long rate hike run.

Fed officials raised their forecast for GDP growth next year by 0.1 percentage points to 2.5% based on the labor market near full employment, jobless claims at a 48-year low and consumer confidence at an 18-year high. And for the first time, they released a projection for growth in 2021, which stood at 1.8%.  Thus the Fed’s raise of growth forecast for next year means that the rate hike cycle will continue for another year; at least.   In fact, the famous “dot plot” reveals one more rate hike this year and three in 2019.

Thus, the game plan is now very clear for the Fed and the discussions are mostly on how, through what wording the FOMC will end the rate hike cycle beyond 2019. The year when the European Central Bank (ECB) will start doing a repeat of what the Fed has been doing since late-2015.

The headwinds from the Fed tightening cycle along with the US corporates returning back to home following Trump’s tax cuts obviously negatively impacted lira and all the other emerging market currencies. The chart above on emerging market currencies however, tells that while all the emerging market currencies were losing ground in the past three years, lira was an exception in the sense that it was the fastest in down spiraling.  Because as the outflows speeded up from emerging markets putting each emerging economy’s unique macroeconomic fragilities under the spotlights, Turkey ever since has been an outperformer.  The political uncertainties along with an overheated economy reflected as soaring current account deficit, double digit inflation and a handicapped central bank were of course the main reasons.  Come 2018, so far lira lost almost half of its value against the US dollar as the Turkish economy’s sustainability was at the core of the problem given the heavily indebted private sector.

Thus, the initial reaction of lira to Fed’s well anticipated decision on Wednesday was rather on the opposite side as it gained ground.

The central bank’s rate hikes in 2018 with the final stroke of 625 basis points of course has helped in terms of sending shock waves that could stop the free fall. The AKP government also gained time with the announcement of the three-year New Economy Program (NEP) which appeared to be a derivate of an IMF package with its credibility lacking amidst the absence of funds that Turkey will apparently be needing when it comes to the rising real sector solvency problems in the near future.  Still, with a touch of grasp of reality within the NEP, the Turkish government has been given the benefit of doubt by the markets-again-though maybe for the last time.  Thus lira seems stabilized at the current 6.00-6.30 levels against the US dollar.

Now that the Fed has announced it will shift to positive real rates that will soon be cooling down the US economic growth in 2020-21, the emerging market currencies no doubt will remain on the depreciation path in 2019.  Yet, with an awoken central bank in Turkey, NEP at hand as a benchmark, lira steeply being an underperforming currency throughout in 2018, now it’s time for lira to remain range bound at the current levels before the market grades the Turkish economic administration on delivering what was promised in the NEW.

Whether the AKP administration will be keeping along the lines of the fiscal austerity promised is not likely to be crystallized before the end of the fourth quarter when the government would be busy with the stress test in the banking sector and well into the first quarter of 2019 .11

Thus, even with a fourth rate hike from Fed in December and the promised 2019 three more rate hikes in the horizon; we can expect lira to remain flat at around current levels until well into the first few months of 2019.

Still, an appreciation is hardly in the cards unless of course a credible IMF program comes in which is not likely before the March local elections. Firstly, because the Fed will remain engaged to its rate hike trend creating volatility in the emerging markets and the first signals from the ECB about rate hikes are also due in 2019; appreciation is not likely in the emerging market currencies.

However, lira’s fate will be set on the government’s NEP performance and of course the private sector’s ability to pay fx debt when the economy is set to remain in a contracting trend throughout 1H19.

Any bout of depreciation that seems possible is likely to get tangible starting from 2Q19.  Thus, lira is likely to stay immune from today’s Fed’s rate hike and the possible fourth hike in December.  Then as the Fed is expected to start signaling an end of its rate hike cycle beyond 2019 and emerging market currencies start stabilizing; whether lira would remain on the depreciation path in the later months of 2019 will all be in the hands of the AKP government’s performance on balancing and reforming the Turkish economy along with dealing the pressures of external debt payments and its effects on the banking sector; in terms of funds needed to keep the economy functioning.

Guldem Atabay

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