Turkish Lira at Risk of Dramatic Losses again as Fears Over Central Bank Independence Resurface

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- TRY extends loss Monday after Erdogan's firing of CBRT Governor.

- Fears over CBRT independence resurface, TRY risks serious losses.

- CBRT credibility as an inflation-fighting force undermined again.

- GBP and USD rose around 60% Vs TRY during the 2018 CBRT crisis.

The Lira fell sharply Monday as markets responded to a Saturday decision by President Recep Erdogan to fire Murat Cetinkaya, governor of the Central Bank of the Republic of Turkey (CBRT), although the Turkish unit remains at risk of dramatic losses against the Pound and Dollar. 

The CBRT said Saturday that deputy governor Murat Uysal has been appointed as Governor of the Central Bank of Turkey following an announcement in the official gazette, with the earlier announcement tipping the market off to the controversial changing of the guard. 

"In his first statement as Governor, Mr. Uysal emphasized that the Bank will continue to independently implement monetary policy instruments focused on achieving and maintaining its primary objective of price stability in line with the duties and responsibilities granted to him by law," the CBRT says. 

Above: Pound-to-Lira rate at hourly intervals, alongside USD/TRY rate (orange line, left axis).

Uysal, who replaces Murat Centinkaya and had been deputy governor of the bank since June 2016, is a banking industry veteran although he's spent much of his pre-CBRT career at the state-owned Halkbank which could be said to give him a strong indirect connection to the current Turkish government. 

Analysts recoiled in shock Monday at the decision, which comes as Turkey's economy creaks beneath the weight of a 24% interest rate, which was announced in September 2018 after months of spiralling currency devaluation drove the inflation rate up to 20%.  

The double-digit consumer price index was in part the result of a 60% fall in the value of the Lira, which raised the cost of imported goods, with the currency rout coming in response to market perceptions that President Erdogan was preventing the central bank from raising interest rates. 

"Central bank independence is of high value. Managing the valuation of fiat paper money without it is significantly less successful. This fact has nothing to do with the status of Turkey as an "emerging market" or with evil speculative forces," says Ulrich Leuchtmann, head of FX strategy at Commerzbank. "With Erdogan's decision, it is crystal clear that Turkey is on the wrong path. Without a quick U-turn this can only end in accelerating inflation and TRY depreciation."

Above: Pound-to-Lira rate shown at daily intervals.

Financial markets, particularly bond and currency markets, have a severe aversion to political meddling in the affairs of central banks given the risk that politically-motivated decisions can pose to creditors of sovereign governments.

Central banks are tasked with using interest rates to manage inflation in their respective economies, with interest rate rises being used to reduce inflation pressures by cooling the economy until consumer price growth falls to a target level. Lower rates are used to stimulate lift inflation by encouraging activity with lower financing costs.

Governments can easily be tempted to pressure central banks into keeping interest rates low for electoral reasons, because rising rates lead to slower growth and sometimes job losses, but this kind of decision almost always gives rise to market fears over the inflation outlook.

After all, when rates are kept too low for too long and inflation rises progressively, it can eat into the returns of investors who lend a country money via the bond market. Among other things, this can see investors become unwilling to hold a country's assets, or at least to demand even higher rates interest than they otherwise would have.

"With the sacking of Cetinkaya, President Erdogan has made clear that he has the last saying in terms of monetary policy," Lecuhtmann says. "The timing of Erdogan's decision has the potential to amplify the TRY-negative effect. Friday's US labor market report decreased the expected amount of Fed rate cuts. The expected carry advantage of the lira is melting from both sides."

Above: USD/TRY rate shown at daily intervals.

The Lira had risen strongly against the U.S. Dollar and Pound Sterling during June after financial markets increased their bets that developed world central banks like the Federal Reserve and Bank of England would soon reduce their interest rates, which made the 24% cash rate of the CBRT increasingly attractive to yield-hungry investors. 

With U.S. interest rates at 2.5% and the BoE cash rate at 0.75%, investors were able to earn a handsome return by selling their U.S. and UK assets in favour of Turkish ones, but that additional return now looks likely to be eaten away by rising inflation and interest rate cuts from the CBRT. 

Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. Rising rates have the opposite effect.

"To be determined is whether the cuts that the CBRT was already priced to deliver at its next meeting (Jul 25) will be enough to satisfy Erdogan, or whether he will push for more until he gets his way (opening the way to a deeper TRY crisis)," says Elsa Lignos, head of FX strategy at RBC Capital Markets. "Our long TRY/ZAR position is still in the money but we will close it out this week as short-term risks build."

Above: Pound-to-Lira rate at weekly intervals, alongside USD/TRY rate (orange line, left axis).

The CBRT was expected to begin cutting rates at the end of this month after inflation fell progressively in the months since October 2018 and as the Lira benefited from international flows out of the Dollar and into other assets.

Those expected rate cuts, which could have seen the cash rate fall by 500 basis points to 19% this month before declining all the way to 10% by the end of 2020, may still be on the way but the outlook for the Lira has turned for the worse. 

RBC's Lignos had previously recommended the bank's clients buy the Lira but she's now planning on scrapping that recommendation. In addition, she's warned clients the Lira faces the additional risk of U.S. and EU sanctions.

Turkey is expected Monday to take delivery of missiles for the Russian S400 air defence system and is reported to have sent a second ship to contested waters off Cyprus to begin drilling for raw materials in defiance of a warning from the EU. Lignos is not alone in being concerned about the outlook. 

"In a nutshell, it does seem to us like a perfect storm is in the making for Turkey and Turkish assets, which could spill over into other markets as well," says Cristian Maggio, head of emerging market strategy at TD Securities. "If the lira triggers some sharp deleveraging of risk amongst global investors (and locals alike), we cannot exclude a repeat, on a smaller scale, of the August 2018 emerging market selloff." 

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