The negative economic headlines about Turkey have been abundant in financial news recently. The reasons not to own Turkish assets (NYSEARCA:TUR) have been well documented and publicized by financial pundits and economists, including but not limited to: The tapering of quantitative easing in the United States leading to capital outflows from emerging markets, Turkey's current account deficit of approximately 7%, and the political pressure exerted on the Central Bank of the Republic of Turkey ("CBRT") by the Turkish government. While the Lira has been pummeled in the currency markets recently, we believe that the CBRT raising rates signals a reversal in the Turkish Lira.
The Lira, in its current incarnation, has a rather brief history. After years of severe inflation in the 1990s, the new Turkish Lira was created on January 1, 2005 to be exchanged for 1,000,000 old Liras. Thus, the history of the Lira, in its current form, spans for less than a decade.
Consequently, when analyzing how the Turkish Lira has reacted to capital outflows, the data is rather limited. Fortunately, the current crisis in Turkey is remarkably similar to what occurred in 2006. The Turkish Lira was slightly above 1.30 Liras per US Dollar at the beginning of May 2006, but reached 1.70 Liras by June 25, 2006. The press release issued by the CBRT explaining their decision to raise interest rates by 225 basis points on June 25, 2006 could have easily been describing the current circumstances in 2014:
The volatility in international financial markets… results from the serious shrinkage in demand for financial assets of developing countries due to portfolio movements triggered by the process of monetary tightening and interest hikes in the developed countries. This demand shrinkage has exerted pressure on both foreign exchange rates and medium and short-term interest rates in developing countries… Turkey has significantly been influenced by these developments because of the structure of the portfolio held by non-residents.
The interest rate hike proved to be sufficient in halting the Lira's slide and the Lira would strengthen to below 1.45 by the end of 2007.
Why The Lira May Have Made A Bottom
We believe that the Turkish Lira reversed its path when the CBRT announced it would hold an emergency meeting. As previously mentioned in this article, the Lira experienced a similar depreciation in 2006 due to capital outflows due to interest rates rising in developed markets which the CBRT managed to stem by aggressively raising interest rates. Furthermore, with the rise in interest rates, Turkey is one of the few currencies that offer investors a positive real interest rate.
While the Lira lost much of the gains it made after the interest rate hike, this was probably due to the following reasons: 1) The market priced in a 225 basis point rate hike prior to the press release based on the actions of the CBRT in 2006 leading to the Lira strengthening in anticipation of a rate hike; 2) The market confused the rate hike to be in excess of 400 basis points due to the CBRT using multiple short term interest rates leading to a further strengthening in the Lira; 3) The market realized that the interest rate was actually raised 225 basis points as the CBRT stated that, "the Central Bank liquidity will be provided primarily from one-week repo rate instead of the marginal funding rate in the forthcoming period." Since the primary rate was the marginal funding rate at 7.75% prior to the emergency meeting, and the one-week repo was designated as the new primary rate rose to 10.00%, the de facto tightening was equal to 225 basis points. This lead to a sharp pullback in the Lira as markets realized the sleight of hand by the CBRT. We believe this confusion has contributed to the Lira's recent volatility and explains why the Lira has merely stabilized instead of strengthening. In the coming months we believe the Lira will strengthen further, perhaps with the aid of an additional interest rate hike from the CBRT.
The recent rate hike of 225 basis points from 7.75% to 10.00% admittedly has its drawbacks as tighter monetary conditions will be a drag on the economy. And while it is a bitter medicine to take, it will eventually help Turkey regain a sounder economic footing. A higher interest rate will address Turkey's external financing needs both in the short and long term. In the short term, a higher interest rate should help boost the Lira and attract foreign capital to Turkey to help stabilize Turkey's external financing. In the long term, a higher real interest rate should boost the savings rate in Turkey and eventually reduce the current account deficit. Furthermore, while 10% interest rates may seem excessive to developed nations, it is not an abnormally high rate in Turkey which is experiencing 7% inflation and has seen much higher interest rates in the past.
In short, while we are cognizant of the obstacles ahead for the Turkish Lira, we believe that the Turkish Lira is poised for a rebound in the coming months and believe that Forex traders should buy the Turkish Lira while using the US dollar, Euro, Japanese Yen, or Swiss Franc as the funding currency.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: Aurei Associates has a long position on the Turkish Lira for its clients and have instructed clients to purchase TUR.