Ground Control to Major Tom…

The month of February will probably be viewed, in retrospect, as a time when the somewhat excessive exuberance of the preceding months subsided and a sense of realism pervaded the market. But isn’t that generally the case anyway: hopes that turning the page to a new calendar year will usher in earth-shaking shifts give way, all of a sudden, to the realisation that economic trends do not change all that quickly. There is nothing disconcerting about that, though... It could even be considered a healthy correction, as it might pave the way for favourable market trends to be based on more solid foundations.
A similar pattern is already evident in global markets: the year started with expectations of an overall recovery, which promptly reflected on long-term bond prices, while stock exchange indices started testing 5-year highs... However, judging from the significant asset price gyrations, no decisive market trend seems in place for now. Regarding markets, news flow from the US will likely be of greatest significance in the short haul. While efforts in the US to find a lasting solution to the automatic spending cut slated to take effect on March 1, 2013 -- following a 2-month deferral as of the new year -- will be high on the agenda until the end of the month, opposing views within the FOMC as regards the FED’s open-ended asset purchases will also be keenly eyed.

As for the Turkish economy, we see no reason to alter our overall view of the year 2013, as fine-tuning in policy implementations will likely suffice in what seems to be essentially a year of safeguarding the gains. One key source of risk is for growth rate to fall substantially short of potential growth rate, as in 2012: such a development would be greeted with greater tolerance by the CBT -- intent to protect the improvement in external balances -- though a similar approach is not to be expected from the political administration. Such a situation would prompt limitations to the flexibility enjoyed by the CBT in terms of shifting its focus to different targets when necessary -- the predominant source of its effectiveness -- in the framework of its multi-instrument, multi-target monetary policy implementation. As we mentioned earlier, the CBT, which bases monetary policy communication on three intermediate variables (inflation expectations, loan growth and real exchange rate), has diverted its focus recently to more imminent risks such as acceleration in loan growth and appreciation pressure on the TRL, given a lack of threats from inflation expectations to medium-term inflation outlook.

From a short-term perspective, while 4Q12 growth data point to contraction in all key markets including the US, PMI indices -- a key leading indicator -- suggest global recovery will gain traction, bolstering hopes for the future. On the other hand, growth in Turkey has remained lacklustre in the last quarter -- confounding expectations -- and leading indicators for January do not quite support hopes of a recovery. Yet, this does not seem to affect growth perceptions for 2013, as the survey median remains unchanged at 4.2%. Moreover, although inflation has topped 7% in January with tax adjustments, deterioration in inflation expectations should be limited as long as volatility remains subdued in exchange rates and commodity prices. 

As for financial markets, our view expressed in our previous monthly report that the stock exchange index was in overbought territory was validated by the ensuing correction. In our view, selling pressure will persist for some time, subsequently leading to more of a range-bound bias. Regarding interest rates, on the other hand, the upward trend should continue, to be felt more on the long end of the curve. As for FX rates, given the CBT’s well-known stance and the framework drawn for real exchange rates, we continue to expect the TRL/currency basket not to fall below 2.05 and to fluctuate within a band of 2.05 - 2.15 through the course of 2013.

Three-way Betting

The second Monetary Policy Committee (MPC) meeting of 2013 will be held on Tuesday, February 19. While we will be providing our views as to potential decisions by the MPC at this meeting in the following paragraphs of this note, we first need to underline that the recent emphasis by the CBT on monetary policy decisions being “data-dependent” has increased the uncertainty compared to before, thereby raising the possibility of a surprise decision by the monetary authority. This is because data are objective, while analyses are subjective, and differences in interpretation among market players and the CBT might prove more substantive than ever.

Let us remind investors of key messages provided by the CBT at the January MPC meeting and the subsequent Inflation Report (IR): “Inflation forecasts assume that monetary policy decisions are data dependent. In other words, it is envisaged that credit and exchange rates follow a stable course and aggregate demand conditions are kept at levels that do not exert upside pressure on inflation. Accordingly, in response to incoming information regarding price stability and financial stability; short term interest rates, liquidity instruments, and macroprudential measures are set in a flexible and coordinated way. Therefore, the forecasts envisage an outlook where macro financial risks arising from the recent surge in capital inflows risks are contained. Forecasts are based on the assumption that annual loan growth rate will hover at around 15% and there will be no significant change in the real effective exchange rate. (…) Financial conditions index has continued to ease with rapid capital inflows, improving credit supply conditions, and accommodative liquidity policy. These developments point to the risk of further acceleration in credit and domestic demand for the forthcoming period, necessitating a cautious stance against macro financial risks. Therefore, in its first monthly meeting of 2013, the Committee highlighted the faster-than- expected credit growth and signalled that macroprudential measures might be continued should this trend persist.”

Under the light of these principal messages and despite the absence of any hints by the MPC at the January meeting, expectations of a “measured adjustment to the interest rate corridor” and continuation of RR hikes do seem reasonable, in our view, considering recent data flow and most notably changes in the real effective exchange rate (REER) -- a closely followed intermediate variable by the CBT -- and loans.

On the other hand, looking at the same data juxtaposed against the macro setting, and also considering Governor Basci’s remarks following the issuance of the IR, a wait-and-see approach by the MPC also seems somewhat plausible. Investors might recall that in the Q&A session of the IR meeting, Basci had stated that the measures taken so far on the RRR seemed sufficient to rein in loan growth at this stage, adding that the loan growth target was not too rigid. On the other hand, the REER had exceeded the “overvalued” threshold of 120 identified by the CBT in January, backing the monetary authority’s last action of a 25bp cut at the lower band of the interest rate corridor. Month-to-date in February, the REER continues to hover at about the January level, still within the CBT’s tolerance interval, as projected through 1.5-2.0% real appreciation annually. Based on our inflation forecast, the REER is likely to fluctuate at around the 120 mark in February, unless the TRL weakens to beyond 2.065 against the currency basket through the reminder of the month.

Finally, from today’s vantage point, neither the overshoot in inflation nor the undershoot in growth is expected to trigger a change in the CBT’s policy stance. Monetary policy is currently being shaped by the real performance of the TRL and the course of loan growth. Note that a cut at the lower band is aimed solely at deterring capital inflows, and is not expected to provide any additional stimulus to economic activity. Otherwise, we expect the CBT to maintain the policy rate at the current level.

Therefore, we think the following three courses of action lie before the CBT: i) Actions similar to January MPC meeting resolutions; i.e. shifting lower the interest rate corridor in a measured way, and implementing minor hikes in TRL/FX RRRs; ii) Maintaining the status quo, but providing the message that they stand ready to act, if need be; iii) A symbolic tightening in RRRs. We attach slightly higher probability to the second option, while acknowledging that a symbolic tightening in RRRs per se would strengthen the cautious stance regarding financial stability.

Last but not least, we attach significant importance to press reports claiming a lack of coordination between the CBT and the Banking Regulation and Supervision Agency (BRSA) and the subsequent joint denial by the institutions. Actually, we had emphasized the significance of coordination in our earlier assessment: “…The reserve requirement hikes introduced by the CBT within the first half of 2011 had not proved that effective in tempering loan growth; rather, loan growth was restrained eventually thanks to the measures adopted by the BRSA in June. While it might behoove the BRSA to act in a similar way in the coming months, we reckon the lesson hopefully drawn from the 2011 experience might lead to improved coordination among relevant institutions….” In this sense, the following joint statement by the CBT and the BRSA is relieving, in our view: “…Regulations that are relevant to more than one institution are discussed at the Financial Stability Committee level and any decision is made following mutual exchange of opinion. Our institutions will continue their works, as before, on the basis of rapport and mutual cooperation.”

Sometimes the Best Offense Is a Good Defence

The New Year kicked off with a distinct strengthening in global risk appetite, as the fiscal cliff was averted, albeit temporarily, thanks to a last-ditch tax revenue deal, along with a two-month reprieve to resolve the outstanding debt ceiling and spending cut issues. Not that the minutes of the December FOMC meeting left investors unfazed… While it was reiterated in the minutes that open-ended asset purchases would continue in the short term, the fact that some members cited the unfavourable consequences of QE, expressing their views that purchases could be pared back or even terminated mid-year, i.e. somewhat earlier than expected, provoked scepticism. The first reaction to this news unsurprisingly came from 10-year US treasuries, the yields on which jumped up to 20bp. Though the ensuing turmoil appears to have subsided in recent days, the fact that Governor Bernanke failed to clarify this matter in his first speech to follow the publication of the minutes meant the continuation of uncertainty, suggesting related developments should be closely monitored from the standpoint of market equilibria. As for the Turkish economy, we reiterate our view that the overarching theme of 2013 will be the preservation of gains. As such, we feel fine-tuning, rather than drastic changes in policy implementations, will suffice. The implication for the Central Bank is the establishment -- and even more crucially the safeguarding -- of an environment conducive to balanced growth. Besides, the Bank has signalled balanced growth for 2013 with its following statement: “We will let domestic demand contribute to growth to the extent that external demand recovers”. It will continue to communicate any progress to this end via the following three intermediate targets: inflation, loan growth and the real exchange rate. At this stage, given a lack of threats to medium term inflation outlook in terms of inflation expectations, the Bank appears more likely to focus on more imminent threats such as acceleration in loan growth and appreciation pressure on the TRL. Loan growth, which closed last year somewhat above targets and started the New Year with unabated strength, appears to be the key challenge for the Bank. To the extent that loan growth deviates from targets, the possibility of additional burdens on banks from the CBT and/or the BRSA will have increased. Nevertheless, we remain of the view that the Bank will not consider the loan growth target as a rigid boundary, rather that it will evaluate it with a flexible approach, taking into consideration its reflections on domestic economic activity. From a short term perspective, on the other hand, disclosures by the ECB suggesting the worst was left behind, and Spanish bond yields dipping below 5%, have contributed to an upbeat start to the year. While PMI indices, which we consider among the most crucial leading indicators, signify sustained recovery -- that is stronger in China and the US, and less so elsewhere -- the nearest hurdle that needs to be surmounted so that the recovery may gain traction appears to be the fiscal policy uncertainty in the US, which should be resolved until mid-February. As for Turkey, we observe some strengthening in growth as of the last quarter of 2012, though this still seems short of the potential growth rate. Initial growth rate forecasts for 2013 appear to average at around 4.2% levels. On the other hand, we reckon inflation may once again edge closer to 7% levels in January along with tax adjustments, though provided that the prevailing muted volatility in FX rates and commodity prices is sustained, we reckon any deterioration in inflation expectations seems unlikely. Initial survey findings point to 6.3% for YE13 average CPI expectations. As for markets, while the ISE benchmark index continues its venture “into uncharted waters”, we reckon we might have reached overbought territory and the odds of a shift henceforth to a sideways pattern appear to have increased. In terms of interest rates, on the other hand, the rebound we anticipated from historic lows has occurred and we now expect the upward trend to continue, and be more pronounced at the longer end of the yield curve. Regarding FX, in view of the CBT’s known stance and the framework it has drawn for real exchange rates, we do not expect the currency basket to slip below the 2.05 mark, rather to fluctuate within the 2.05 - 2.15 band through the course of the year.