Acting Like A Strategist (September MPC preview)

Maintaining financial stability will clearly remain at the heart of the CBT’s policy agenda, in our view, at the forthcoming MPC meeting on Tuesday, September 17. As such, the rhetoric to be employed by the MPC at this ninth meeting of the year, and potential resolutions, will likely amount to a stamp of approval for the stance recently adopted by the CBT. Hence, the meeting should largely prove a non-event for markets. The only measure we would expect out of the September MPC meeting is a change in mechanisms for FX liquidity provision, as flagged during the Ankara meeting.

In a scenario featuring capital outflows, possible reactions by the monetary authority in the framework of ROM mechanism -- in a bid to play a balancing role in terms of FX liquidity -- are provided below. Considering the prevailing state of affairs, option (b) appears to us as the most viable course of action:  

(a) The CBT reduces the ROC, and FX reserves kept by the banks with the CBT decline. As a result, FX supply in the market increases; TRL liquidity remains constant; and the intervention is aimed more at the volatility -- rather than the level -- of the TRL. This is similar to a sterilised FX intervention. As regards monetary stance and credits, it would correspond to an easing.  

(b) As an alternative to a change in ROC, the reserve option rate may be reduced. In such a situation, because the FX reserves banks may keep with the CBT would decrease, this would foster FX supply in the market. On the other hand, TRL liquidity would tighten and the deprecation of the TRL would be limited. This may be considered as a mechanism comparable with a non-sterilised FX intervention, which is aimed more at the level -- rather than the volatility -- of the TRL. As regards monetary stance and credits, it would amount to a tightening.  

(c) The CBT cuts the FX RRR, and FX reserves kept by the banks with the CBT decline. As a result, FX supply in the market increases; TRL liquidity remains constant; and the intervention is aimed more at the volatility -- rather than the level -- of the TRL. This is similar to a sterilised FX sale intervention. As regards monetary stance and credits, it would correspond to an easing.

August MPC Meeting: Door left open for further monetary tightening… At the previous meeting, the CBT had hiked the upper band of the interest rate corridor by 50bp to 7.75%, while leaving the lower band and the policy rate stable at 3.5% and 4.5%, respectively. However, the interest rate on borrowing facilities provided to primary dealers was kept unchanged at 6.75%. In other words, the CBT continued to provide funding to primary dealers at 6.75% on “normal” days, but the funding rate would increase to as high as 7.75% on “exceptional” days. In the statement, the CBT left the door open for further monetary tightening by reiterating the following: i) “cautious stance will be maintained until inflation outlook is in line with medium-term targets”; ii) “additional monetary tightening will be implemented when necessary”.

Currency tumbles: CBT changes tactics… As the TRL came under major selling pressure and bond yields soared in the aftermath of the MPC meeting, Governor Basci held a press briefing, where he unveiled the new monetary stance, along with a shot of verbal intervention in FX (pronounced year-end US$/TRL level as 1.92). The new stance envisages eliminating the “uncertainty in interest rates” i.e. the CBT will implement a predictable monetary policy, which is expected to foster interest rate stability. As we already know, this implies that all rates (policy and corridor) will remain stable until further notice, and cost of CBT funding may vary within a range of 6.75 – 7.75%.

Principal objective: to mitigate sensitivity of TRL interest rates to global rates -- The monetary authority sought to achieve this via breaking the negative feedback loop between rate hike expectations and domestic currency depreciation. By doing so, the CBT tried to insulate domestic markets from volatility generated by data surprises driven by Fed tapering. In the presentations published after this communication, the CBT described this strategy as follows: “Predictability of Turkish lira liquidity policies are increased, while dependence on high frequency data is eliminated.” As we had commented earlier, the main aim is to attract interest in local bonds by fixing the funding rate, and we think the short-end of the bond yield curve would benefit the most from this stance.

However, the flipside of this policy would inevitably be higher FX volatility, which means continued depreciation pressure on the TRL, at least until the Fed provides clear policy messages. Since the CBT will not use the interest rate weapon against the exchange rate, this strategy requires additional instruments providing FX and LC liquidity. Since we surmise there are no new tools (swap, option or forward) to defend the TRL, CBT officials pinpointed the Bank’s FX reserves as a main defence mechanism. According to Deputy Governor Kenc, the CBT could use not only net FX reserves (US$40bn), but also most of the gross FX reserves (FX ROM US$32.1bn and FX RRR US$28.1bn) if need be. In that regard, first of all the CBT will continue to inject liquidity through daily FX selling auctions and be “offensive”. Moreover, CBT officials suggested that FX liquidity would be provided from gross reserves via ROM and FX required reserves, if needed.

In fact, the CBT expects the TRL and LC interest rates to adjust -- on the back of greater interest on the part of foreign investors in local bonds -- after having overshot initially. This expectation is discernible also from the recent presentation (Governor Basci’s Presentation at OMFIF Meeting on "The Role of Emerging Market Economies in Building World Prosperity"); i.e. sections devoted to bond yields and REER. Regarding yields, Governor Basci described the current situation as an “overreaction”, voicing his expectation for “mean reversion”, which implies around 100-125bp fall in 3m and 2y yields from the levels observed on September 2.

Betting on mean reversion: viable, yet risky… The “overreaction” message for the TRL was communicated through the projected level of the Real Effective Exchange Rate (REER) Index, and a new lower bound was added to stress the undervaluation of the TRL. We already knew that the CBT had drawn a red line for the TRL’s overvaluation, referring to the trend line of 2% annual appreciation that starts with the index base (May 2003=100) and reaches around 120 level this year. This has been considered an upper bound for the REER throughout the year. Conversely, the new line sets a lower bound for the “fair” value of the REER, drawn by starting from the initial value (Jan 2003=90) of that index and with the same appreciation trend. Based on the CBT’s calculations, September REER may dip far below the new line, assuming the exchange rates (FX basket 2.38 against TRL) prevailing at the early days of September being sustained throughout the month. The graph denotes the CBT’s expectations for mean reversion in an uncertain timeframe. We believe the now famous 1.92 level for the US$/TRL is a product of this exercise. Nevertheless, at the Ankara CBT-Investor meeting, Deputy Governor Kenc sought to downplay the significance of this parity, claiming this was merely an example to underline the fact that EM currencies typically appreciate after underperforming, and this is bound to happen to the TRL as well in an uncertain timeframe.

In our understanding, the CBT is first introducing a shock to trigger an overshoot in the FX market, and then betting on mean reversion. We continue to view this as a feasible, albeit risky strategy, predicated apparently on the assumption of a possible relief to follow the resolution of the Fed policy uncertainty with the September 17-18 meeting.