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No summer lull for volatility
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No summer lull for volatility

Turkey’s historic currency devaluation continued to dominate the financial headlines this week. Probably the best summing up of the country’s insufficient response was given by Fitch, the ratings agency: “an ad hoc and incomplete policy response cannot fully address the underlying causes of the lira’s fall, namely the large current account deficit and external financing requirements [~ $230bn, well in excess of official FX reserves], the jump in inflation (to 15.9% in July), the build-up in foreign currency debt, and deterioration in economic policymaking credibility.”

At the end of last week the currency slumped by 6% to 6.010, and has continued to fall this Monday morning (6.090 at the time of writing), even as Turkey unveiled a raft of measures aimed predominantly at short sellers of the Lira. Crucially, what was not unveiled, were the two things that are generally required by investors around the world: raising of interest rates and tightening of financial conditions. Fitch states that, in order to stabilise the Lira, the Central Bank of the Republic of Turkey must establish a real rate that sufficiently reflects the country’s risk premium and supports disinflation, thereby re-establishing a nominal anchor and eventually attracting capital inflows. Combine the current unorthodox response with a generally stronger US dollar, rising US interest rates, global trade tensions, and a deteriorating political relationship with the US over a US pastor held in the country, and there are ample internal and external reasons that the Lira has moved as far as it has. Speaking last Friday after a Turkish court rejected the American pastor’s appeal for release, President Trump reinforced the ill feeling between the countries: “So, we haven’t seen the last of that. We are not going to take it sitting down. They can’t take our people.”

Following Erdogan’s violent response to an attempted coup in 2016, accompanied by a crackdown on media, Kurdish opposition and civil society; diplomatic ties between Ankara and most European capitals have been frayed. Signs of a thawing in tensions became evident last week through positive communications between Erdogan, Germany’s Angela Merkel and France’s Emmanuel Macron. It is no coincidence that as relations between the US and Turkey plumb new lows, the EU is attempting to extend some assistance to its neighbour. Indeed, last week Turkey, in a show of good faith to the EU, released from prison two Greek soldiers suspected of espionage and the detained national head of Amnesty International. However, it remains to be seen how much the EU can do: the bloc’s main instrument of macro-financial help is reliant on an IMF bailout, a matter on which Turkey has remained reticent to date.

The spill-over into other emerging currencies, as measured by their exchange rates against the USD, has resulted in considerable devaluation across the board: the Indian Rupee (down 9% since April), Russian Rouble (down 7% since July, 15% since April), Brazilian Real (down 4% since July and 15% ytd) and the SA Rand (down 18% since April and 10% since July). Needless to say, these moves continue to provide interesting hedging opportunities – albeit in markets with lower liquidity than usual.

EURUSD has also traded as low as 1.1344 (its lowest in a year), though it is currently on the rebound and stabilised this morning at a low 1.14 handle. The knock-on risk of potential contagion into Europe – particularly in light of certain European banks’ significant exposure to Turkey – has seen 5-year EUR swaps push to as low as 26bps from 40bps three months ago. Meanwhile, the longer end (20 years) is also back down to sub 140bps from the year’s high of 165bps in February.

Today also marks Greece’s exit from eight years of international bailout programmes. Greece, though now experiencing economic growth, still has a long way to go to fix its banking system and stoke anaemic domestic demand and investment. According to the Bank of Greece, non-performing loans account for 48% of the country’s total loans outstanding, which is 10 times the European average. This milestone deserves to be celebrated.

However, last week Italy renewed the tremors across European markets as Rome’s politicians launched a verbal bombardment on Europe’s establishment. The Italian 10yr government bond already yields over 3%, versus its German equivalent at ~30bps. This autumn, Italy’s new populist government – comprising the League and the anti-establishment 5 Star Movement – must present its budget explaining how it intends to pay for costly election promises. Bond investors will be watching closely.

Upcoming economic releases

This week, the ECB will publish July’s monetary policy meeting notes. There were no changes to policy or forward guidance at that meeting, but President Draghi appeared to endorse investors’ view that the deposit rate will remain negative until 2020.

Central banker’s summer holidays end as leaders gather for the Federal Reserve’s annual policy symposium in Jackson Hole, Wyoming. Of particular note will be the speech by the Fed’s chair, Jerome Powell, on Friday morning (Friday afternoon UK time). Expect commentary on the likely path of interest rates, balance sheet policy, and the Fed’s take on emerging market turmoil. The US central bank is expected to raise interest rates for a third time this year in September, with a fourth hike in December also on the cards, but with lower certainty.

 

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