Turkish yield curve inverts on rate hike speculation

Tourists check currency exchange rates outside an currency exchange office in central Istanbul January 6, 2014. (REUTERS/Murad Sezer)

ISTANBUL: Turkey’s government bond yield curve has inverted for the first time in six months, suggesting a growing number of traders are betting the central bank will be forced into a large interest rate hike to support the lira.

The yield on two-year lira government bonds was quoted at 10.23 percent Tuesday, a touch higher than 10-year bonds at 10.16 percent, traders said.

The break with the normal pattern of investors accepting lower yields to hold shorter-term bonds reflects intense pressure on Turkish markets. The lira has weakened more than 7 percent against the U.S. dollar since the end of November because of a corruption scandal shaking the government, as well as on a general move to shift capital out of emerging markets.

While some eurozone bond curves have inverted in the last few years at times when investors feared countries might soon default on their debt, Turkey’s ability to repay is not a concern, the traders said.

Fitch Ratings warned in a report Tuesday that the scandal had the capacity to weaken Turkey’s creditworthiness eventually, but said that so far there had been no impact on the country’s BBB- rating or its wider economic outlook.

Instead, some traders think the Turkish central bank, which has so far resisted the idea of major monetary tightening, will be forced into it at some time in coming months by high inflation and the need to support the lira. “Turkish short-term bond yields have breached long-term yields because markets are pricing in a rate hike from central bank,” said Ugur Kucuk, fixed income strategist at IS Investment.

“The central bank clearly stated that they will not give a policy response to lira weakness. However, we think the central bank may need to respond to rising inflation after the latest tax hikes and the forex pass-through effect,” he said. Lira weakness feeds inflation by raising prices of imported goods.

The last time that the government bond curve inverted was in July 2013, when the spread between two- and 10-year bonds was minus 5 basis points, traders said. Before that there was a 10 bp inversion in April 2012, and an inversion of as much as 160 bps between August and October 2011.

The inversions in 2013 and 2011 both preceded interest rate hikes. In October 2011 the central bank announced a dramatic reversal of its dovish policy, raising its overnight lending rate by 350 bps to fight a surge of inflation.

Although the central bank lifted the overnight lending rate by 125 bps to 7.75 percent in the second half of last year, it has resisted market pressure for much larger hikes – many in the market think rate rises of 300 or even 400 bps from current levels may be needed to stabilize the lira.

With the government facing local and presidential elections in March and August, it does not see higher interest rates hurting mortgage-payers and construction companies which have taken on heavy debt.

Finance Minister Mehmet Simsek indicated Tuesday that he expected the low-rate monetary policy to continue, saying turkey was taking measures to keep domestic demand at reasonable levels without resorting to interest rate hikes.

“The central bank, banking watchdog, Finance Ministry and Treasury got together; we limited loan growth with capital adequacy ratios and macroprudential measures, without resorting to rate hikes,” Simsek told CNN Turk television.

However, with the lira so weak, a growing number of traders think the central bank, scheduled to hold its next monetary policy meeting on Jan. 21, may not be able to stick to its understanding with the government.

Inflation in December was 7.4 percent, well above the central bank’s target of 5 percent, and consumption tax hikes this month are expected by private analysts to add roughly 1 percentage point to inflation.

Simsek himself estimated Tuesday that a 10 percent depreciation of the lira added about 1.5 percentage points to inflation. Combined with the tax hike, that could propel inflation close to double digits unless the lira stabilizes.

Erkin Isik, fixed income strategist at TEB-BNP Paribas, said the central bank might lift the overnight lending rate, the top of the corridor in which it manages banks’ short-term funding costs, on Jan. 21 to counter expectations for higher inflation.

“The market seems to be expecting the central bank to be quite aggressive,” he said.

“We think a measured rate hike is more likely, given the tightening through macroprudential measures on consumer loans and tax hikes in the beginning of the year.”

A version of this article appeared in the print edition of The Daily Star on January 08, 2014, on page 6.




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