Declining volumes in currency trading has been an overriding theme as banks have been subject to stricter regulations on their trading activities. It is early to talk about the recent Trumpflation trade has caused any change globally, but when it comes to trading Turkish lira we still see that shrinking volume is an underlying trend.
Below we present the chart that shows total annual TRY trading volumes in form of forwards, spot trading and swaps.
Clearly 2013 was a turning point when uncertainties around emerging economies started to loom, leading stronger corporate demand for forwards to the end that hedge their FX risks. That period also marked the banks losing interest in TRY spot market. More importantly, we saw a huge drop in swap volume which is consistent with our voluntary deleveraging theory which simply based on Turkish banks’ weaker demand for foreign financing given the extremely high loans-to-deposits ratio (In Turkey banks have increased their foreign borrowings to finance the lending growth due to weakness in deposits, used swaps to hedge those positions). We believe that this credit positive, growth negative.
We note that spot trading volume of TRY declining roughly 14% y/y is worrisome that the currency is now more exposed to liquidity risk. As reported in some media outlets, global investment banks are now kind of through with TRY market. We expect TRY to remain volatile for some time come, which could partly offset by rate hike by the central bank. Our prospect is for a 2017E 10% policy rate and we recommend investors to consider 1-year xccy swaps afterwards.
The monetary policy committee raised 1-week rate by 50 bps to 8% and the upper band by 25 bps to 8.50% vs a consensus expectations split between a 25 bps hike in the 1-week repo change and no change. As a separate decision, the central bank has decreased FX reserve requirements by 50 bps for all maturity brackets, providing $1.5 billion of liquidity to the financial system.
The move came despite the politicians’ strong remarks against high real interest rates, but after Turkish lira has weakened almost 9% against the US dollar (even underperforming the Mexican Peso). To our thinking, this was a rational move but not enough to reduce near term risks. The rate statement noted that despite the disinflationary slowdown in aggregate demand, recent exchange rate movements ─owing to heightened global uncertainty─ posed upside risks to the inflation outlook while it did not provide much forward guidance.
The average cost of funding rate was standing at 7.9% just before the decision, and according to our estimates the rate hike could add another 35 bps, taking it to 8.25% in days to come. That said, we have already seen it rising to 9.05% in two days following the rate decision. We believe much of the devaluation in the local currency has been driven by global market conditions, and Trumpflation trade is likely to lead further downside. While our 2016E USD/TRY target of 3.2 is overshot by a wide margin, we renew our 12-month horizon target at 3.65 for the currency. We also believe that 25 bps hike in the ceiling of the rate corridor may not provide sufficient incentive for deposit holders to stay in TRY.
Previously, we draw a pessimistic future for the inflation outlook in 1H17. Correspondingly, we see further rate hikes by the central bank going forward, and expect the average cost of funding to hit 10% next year, in an effort to provide a compelling real interest rate for TRY holder. In our view, the recovery signals in Q4 ─after a dismal Q3─ on the lending growth front, would provide some comfort for the central bank for tightening. That said, we earlier stated that it was more likely to see fiscal stimulus to support the economic activity in the future (we expect Turkish government to post a budget deficit of 2% as of GDP in 2017).