Inflation to drop, rate cuts to continue

Published 02.07.2014 00:11

The Central Bank of Turkey surprised some investors last week, cutting the benchmark lending rate from 9.5 percent to 8.75 percent. Turkish financial markets had priced in such a move, albeit a more modest one, and markets continued to preserve their gains for the year. Borrowing and repurchasing rates were left intact at 8 percent and 12 percent respectively. Global financial markets continue to be focused on developments in neighboring Iraq where the news is mixed. Last week, ISIS fighters consolidated gains in central Iraq, in preparation for what maybe a larger battle for the capital. The central government in Baghdad has appealed to Russia for urgent assistance after their calls appear to have been bogged down by partisan bickering in Washington.

The Russian response was immediate with the delivery of five Sukhoi fighter jets to the central government in Baghdad in exchange for half a billion dollars. This last move will surely be interpreted as Russian interference in a U.S. sphere of influence and may goad the U.S. into stepping up military support for the Iraqi government. Turkey is one of the largest stakeholders in the future of Iraq and any surprises in the region will move Turkish financial markets.

U.S. Vice-President Joe Biden appears to have been vindicated with the current de facto splitting up of the country into three regions. Biden had earlier predicted a split-up of the country may be the best alternative to a sustained civil war, which may evolve, unless the central government in Baghdad is able to fight ISIS forces. The artificially borders of Iraq, formed from the remnants of the Ottoman Empire, have caused internal turmoil for much of the last century and they may finally be retired. Ironically an independent Kurdish state, something previous Turkish administrations had opposed, will actually be most beneficial to Turkey. The Kurdistan Regional Government (KRG) enjoys friendly relations with Turkey and trade between the two parties fulfills the needs of both Turkey and Kurdistan, natural resources and finished goods respectively. Turkey has indicated it would support the KRG's declaration of independence and support it in any armed conflict.

These developments have been met with cautious optimism by financial markets with the benchmark BIST-100 up for the week, trading at 79,048 points at midday Monday, from the 78,861 level it traded at last week. The Turkish lira is also up 1 percent against the U.S. dollar, on global dollar weakness, trading at 2.12 liras to the dollar. During the announcement of the rate cut last week, the central bank indicated that inflation had peaked and was poised to begin its expected decline this month. Inflation numbers will be announced this Thursday and I predict a larger drop in inflation than consensus estimates. Fixed income markets continued to rally on the rate cut announced by the central bank with the benchmark two-year bond's yield trading at 8.09 percent down over 40 basis points from last week when it had traded at 8.47 percent. The long-end 10-year also rallied with yields dropping to 8.74 percent midday Monday from 8.81 percent.

Credit-default swaps, a good measure of economic and political stability, traded at 1.75 percent, down 3.5 percent from last week, when they had traded around 1.82 percent, and down 35 percent from their peak in the last year. Crises elsewhere coupled with a sluggish European economy continue to make Turkey a destination in the search for "alpha."

The Central Registry Agency's (MKK) "Foreign Participation in Turkish Equity Markets index" was reported to be down to 63.7 percent Monday, off by 50 basis points from last week. Such a significant drop in the last week, while fixed income and equity markets rallied, signals strong domestic demand and apprehension by foreign investors over the future of the ISIS conflict. I continue to doubt the ability of 8,000 fighters to continue to hold onto significant parts of Iraq. With so many petrodollars at stake, sooner or later, the western oil companies that stand the most to lose will lobby their governments to interject in the conflict, which they will.

The presidential election cycle, slated for Aug. 9, enters the home stretch in July as Prime Minister Recep Tayyip Erdogan will most likely have announced his candidacy for president on Tuesday morning. He faces Ekmeleddin Ihsanoglu the candidate of the two largest opposition parties. A virtual unknown to the voting public, Ihsanoglu faces an uphill battle against the most popular political figure in Turkish history.

As the election draws closer, polls that indicate the Prime Minister will win will cause markets to rally up until the election. We may see some profit-taking immediately after the elections, unless the win comes in at over 60 percent, which it very well may do. The bigger question will come after the presidential election. Should Erdogan win, that is, "who will be the next prime minister?" My sources inside Ankara currently point to the foreign minister, Ahmet Davutoglu, leading a short list of successors to the current prime minister.

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