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Piotr Matys, EM FX Strategist at Rabobank, points out that the Turkish lira plunged more than 3% against the basket of USD & EUR after Turkey’s central bank opted to leave the main policy rate unchanged at 17.75% on Tuesday.

Key Quotes

“This was against both our and market expectations for a 100bps hike. The surprising decision reignited market concerns about the independence of the central bank. It was the first monetary policy meeting after the presidential and general elections held in June.”

“The CBRT also missed the opportunity to strengthen its credibility, which was partially restored by the 300bps emergency rate hike on May 28 and the larger than expected 125bps move on June 7.”

“With inflation already three times higher than the official 5% target and likely to rise further in the short-term, the bias was firmly skewed in favour of a hike. Yet, the CBRT decided that monetary policy is already sufficiently tight to rein in inflation.”

“The reluctance to hike could prove costly given that the selling pressure on the lira resurfaced. The price action against the USD & EUR basket implies that the lira may fall to a new record low in coming weeks. The initial target for the bears is set at 5.4924 followed by 5.6712 next.”

“Should such a bearish scenario for the lira unfold, the CBRT may not be able to wait until the next scheduled meeting on September 13 to rectify its monetary policy mistake as implied by the negative market reaction to its decision.”

“Taking into account comments from President Erdogan, who ahead of crucial presidential and general elections held in June explicitly said that he intends to take more responsibility for the monetary policy, Turkey must decide which tools to use to prevent a full-scale currency crisis (after barely avoiding one in May when the lira was falling precipitously).”

“The most market friendly option would be to keep raising interest rates until the lira is sufficiently stable to restore confidence amongst investors.”

“This would have to be accompanied by economic reforms to reduce Turkey’s vulnerabilities and a tighter fiscal policy.”

“To our mind Turkey is attempting to achieve all three of the following simultaneously: keep interest rates at current levels (which are insufficiently high as the market reaction indicated), the lira to remain relatively stable (to avoid inflationary pressure from imports from rising even further) and to maintain a free capital flow.”

“Turkey can control only two out of those three at the same time, according to the impossible trinity concept, also known as the trilemma.”

“Unless interest rates rise further, it is difficult to expect that the lira will stabilise, which means that Turkey may restrict a free movement of capital.”

“We assume that the central bank will respond by raising interest rates should the selling pressure on the lira increases significantly in the coming weeks.”