Mild sanctions won’t affect Turkey, but this isn’t the end
By: Richard Russell
Tags: Trading, Turkey, Finance, Investing

The US will implement light CAATSA sanctions, and the EU will expand their sanctions list. Neither of these will negatively impact Turkey, but this story isn’t over.

On Thursday we had news that the US will impose CAATSA sanctions on Turkey for their purchase of the Russian S-400 missiles as the passage of the NDAA to fund the US military was confirmed by the House, and will most likely be taken up by the Senate. This Act included a rider that mandated the President impose CAATSA sanctions on Turkey in response to its S-400 purchases, and Trump looks to have taken the initiative so that the matter did not fall to Joe Biden when he takes office in January.

The sanctions are likely to be on the very light side of the CAATSA menu of 12 potential sanctions, and will target Turkey’s Presidency of Defence Industries and its head, Ismail Demir, as Trump continues to protect Erdogan from damaging sanctions that would impact the Turkish economy.

In addition, the EU are looking to expand their sanctions against Turkish individuals involved in Turkey’s gas exploration efforts in the Eastern Mediterranean, however the bloc put off decisions on trade tariffs and other measures until the new Biden administration takes office. These measures were a compromise between more hawkish EU members such as Greece, Cyprus, and France, and more conciliatory member states such as Germany and Bulgaria. The hawks had put forward a proposal that Turkish entities be cut-off from funding by EU financial institutions, however this proposal was not seriously considered. Further, the EU called on the European Commission to produce a report by March 2021 at the latest regarding the overall state of EU-Turkey relations, and recommending options on how to proceed.

These sanctions are at the very lightest end of the spectrum that could have reasonably been expected, with neither of these measures likely to cause any noticeable damage to Turkey nor force Turkey to give up the S-400s or prevent Turkey’s gas exploration activities in the Eastern Mediterranean. This also isn’t the end of the story, with further action from the Biden administration and the EU likely in 2021. There is significant bipartisan Congressional determination to force Turkey to give up the S-400s, which is also echoed in NATO, with members of the alliance adamant that the S-400s are incompatible with Turkey’s obligations as a NATO member. In addition, Turkey looks unlikely to stop its gas exploration activities and the EU will wait on cues from Biden as to how to approach Turkish intransigence.

In the end, I expect that the S-400s will never be made operational, and a compromise agreement of some sort will be reached that sees the S-400s mothballed as an appeasement to the Biden administration. What Turkey would want in return isn’t immediately clear, however leniency towards Halkbank in its sanctions busting case, as well as the sale of PATRIOT missiles or more advanced weaponry from the US will likely be options mentioned at the negotiating table.

USDTRY spiked above 8.02 on Friday morning, but ended the day about 0.33% lower.

The headline that sanctions were to be applied by the US caused a small spike on Thursday evening, however the real fireworks began on Friday morning, as USDTRY was pushed from 7.90 above 8.0250 between 7am and 9am London time as the market digested the headline fully. The market then went into reverse and we fell back down to as low as 7.8150 before settling around 7.85.

Source: Bloomberg

This price action highlights to me the two main ‘push/pull’ factors currently at play in the USDTRY spot market. Locals continue to buy USD given high inflation, distrust in the commitment to follow through with economic reforms, and a need to shore up balance sheets given the large amount of FX debt on corporate balance sheets. Against this, international investors are keen to take advantage of very high carry (16%+ 1yr cross-currency yields) given the paucity of other yield options available.

An old market adage says that if assets react well to bad news then the outlook is bullish, given the price action on Friday, that adage would suggest USDTRY is due to head lower.

October current account deficit was the smallest this year at $270mn, however this compares to a $2.7bn surplus in October 2019, and November data implies a worsening in the trade balance.

Turkey posted a current account deficit for the 12th month in a row in October, with this bringing the YTD 2020 current account deficit to $31bn. October was the smallest monthly current account deficit this year, however the preliminary trade balance data for November suggests a $5bn deficit as exports remained flat and imports increased 16%. Given the continued coronavirus lockdowns in Europe, and the energy imports needed for the winter months, Turkey’s current account and trade balances are unlikely to show sustained improvement this year. In addition, tighter monetary policy will be necessary to bring the current account deficit down and stop Turkish savers from buying gold, which has been the dominant driver of Turkey’s current account deficit this year.

Source: Bloomberg

The CBRT will hike rates 150–200bps at their meeting on 24th December.

At their meeting on 24th December the CBRT will hike rates 150–200bps to try and slow the continued dollarisation of Turkish savings, as well as contain inflation which is due to increase to above 15% in Q1 of 2021. The OIS market is currently pricing in 150bps for the December meeting, another 60bps for January, and then 10bps in February for a cumulative 220bps of hikes. This looks low to me, with two hikes of 150–200bps each a more likely scenario in my mind. In addition, the Jan/Feb spread at +10bps looks to be a very asymmetric risk/reward to pay, the CBRT won’t cut rates in February so a -10bps downside looks attractive.

Flows data for the week ended 4th December highlight the continued challenge the CBRT faces, with local FX deposits increasing $3.2bn, with some of this attributed to EURUSD revaluation effects. In addition, foreign inflows into Turkish asset markets for the week were essentially flat, as foreign investors continue to wait for follow through from the new economic management team, with concrete reform steps needed for foreign investors to become excited about investing in Turkey again.

I continue to believe that 2021 will see investor enthusiasm for Turkish assets increase, with the carry available in USDTRY spot positions far outweighing anything else in emerging markets. In addition, TurkGBs remain under-owned by foreigners (<5% of outstanding issuance owned by foreign investors), and BIST equities remain at a ~50% forward P/E discount to the MSCI EM index. Provided the CBRT tighten policy further, and the new economic management team provide substantive reforms to accompany the lofty rhetoric, I continue to believe that Turkey could be the EM darling for foreign investors next year.

Volatility continues to decline in the Turkish FX swap market

The reduced risk of funding squeezes, and the increased investor interest in Turkey has pushed down volatility in the USDTRY FX swap market, with volatility now down to the lows we saw in January of this year and November of 2019.

The average daily range of 1 month USDTRY FX swaps over the past year can be seen in the below graph, with the red line indicating the rolling 14-day average, and the green line indicating the average over the last year. The rolling 14-day average is comfortably below the yearly average at 60bps vs 285bps respectively. This has largely been driven by the lack of funding squeezes encountered since August as a result of the CBRT ceasing to intervene in the spot market, interventions which had periodically drained the offshore FX swap market of liquidity.