Turkish Lira Options Show Currency at Breaking Point After Vote

Netty Ismail

February 2, 2023 at 7:46 a.m.·3 min read

(Bloomberg) -- For months, the Turkish lira held the unfamiliar title of dullest currency in emerging markets. With pivotal elections looming, investors are bracing for a return to form.

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Whether President Recep Tayyip Erdogan extends his two-decade rule, or if the opposition prevails in a tight race, traders ultimately expect volatility to come back and the lira to weaken. Options are pricing an almost 60% probability that the Turkish currency will slump 25% to a new low of 25 against the dollar by the end of the year.

With Erdogan’s unconventional policy of cutting interest rates far below inflation set to continue, Turkish authorities have introduced alternative tools to stabilize the lira. The central bank spent an estimated $108 billion via back-door interventions last year to offset the impact of looser monetary policy, helping make it the least volatile currency in the developing world over the past six months.

Turkey Rebuffs Idea Erdogan Will Allow Higher Rates After Vote

“Numerous unresolved structural problems” mean the longer-term trend is inevitably for a weaker lira, said Cristian Maggio, head of portfolio and ESG strategy at TD Securities. “A continuation of Erdogan’s rule would almost surely coincide with further deterioration in Turkey’s fundamentals, and eventually result in long-term financial instability.”

Erdogan is likely to remain in power after elections “by overcoming voters’ economic concerns,” Emre Peker, Europe director for Eurasia Group, said in a note. The political risk consultancy raised the probability of his re-election to 60% from 55% previously, citing the opposition bloc’s failure to present a credible alternative to Erdogan and two decades of his AK Party rule.

The six-party bloc will select its candidate to run against Erdogan on Feb. 13.

Should they come to power, the opposition could reshape the low-rates approach Erdogan promoted, potentially winning back foreign investors who dumped the nation’s assets in the past four years as the lira slumped to record lows and inflation soared. But Turkey’s gaping current-account deficit, foreign debt burden and weak reserves point to a grim outlook for the currency, whoever wins.

Fragile Calm

Demand for protection against swings in the currency — as measured by six-month implied volatility — has jumped by the most in emerging markets since the start of the year. That’s widened its gap with the three-month tenor to a record, underscoring expectations that policy makers will keep the lira stable before the election in May.

“Should Erdogan win, there is a reasonable chance the lira may remain stable in the weeks and months following the event,” said Paul Greer, a London-based money manager at Fidelity International. “However, macro-economic imbalances will eventually pressurize it to weaken.”

If the opposition prevails, higher interest rates and a roadmap for rebuilding foreign-exchange reserves would give investor confidence a boost, according to Gordon Bowers, a London-based analyst at Columbia Threadneedle Investments.

The opposition parties said last week they would ensure an “independent” central bank that would focus on curbing rampant inflation.

“We’ve never seen such low foreign investor positioning in Turkish local assets ahead of an election under the Erdogan regime,” Bowers said. If a market-friendly opposition comes to power, “the bid to cover Turkey underweights will be immediate and massive.”

Turkey’s debt offers deeply negative real yields after the central bank cut the key rate by 500 basis points to 9% last year. Foreign investors’ holdings of local debt stand at less than $1.3 billion — close to a record low.

Still, any lira appreciation is likely to hit a wall as the broader economic challenges make themselves felt, Bowers said.

--With assistance from Kerim Karakaya.

(Adds comments by Eurasia Group in fifth paragraph)