What's a four-letter profanity currently banned from the hallowed halls of the Federal Reserve (Fed)? The answer is seemingly "data." The current Federal Open Market Committee (FOMC), the interest rate decision making body of the Fed, is led by newly minted Chairman Jay Powell who has made it abundantly clear that the Fed is no longer "data dependent" when it comes to their intentions in raising interest rates for the next two years.
The Fed has chartered a course of six rate hikes of 25 basis points or which five have yet to be announced, bringing rates up from their current range of between 1.5 percent and 1.75 percent to 2.75 percent to 3.0 percent by the end of 2019. In apparent anticipation of the next hike, which could come as early as the next FOMC meeting next week, the Central Bank of the Republic of Turkey (CBRT) announced Wednesday a rate hike of 75 basis points (bps) of the late liquidity window, the current lending apparatus of the bank. The move has brought Turkey into uncharted territory, and the Fed's current path could spell disaster for financial markets everywhere.
The Fed's mandate is clear: Keep inflation at 2 percent and unemployment at or near full employment. Any steps outside of these stated goals would be going off-script and would catch markets off guard leading to 2008-level panic. In an attempt to avoid this, Powell and other Fed officials have said that despite low growth and inflation below 2 percent, currently near 1.7 percent, the Fed fears an unexpected jump in wage growth which would spark increased inflation. While I believe these fears to be unfounded, U.S. President Donald Trump campaigned on raising interest rates. That ship has sailed. The special interests and high net worth individuals who are often associated with the Republican Party stand to benefit the most from high interest rates and they will have their way. While not personally great for developers like Trump, keeping interest rates high is great for Trump's donors who have a vested interest in higher interest rates.
As I have mentioned in previous columns, Turkey is unique in that it has a high beta as a country. The good news and bad news are amplified when translated into market moves, and Wednesday was no exception. The U.S. dollar index hit three-month highs just as the central bank raised rates to 13.5 percent. Ceteris paribus, this would have caused an appreciation in the value of the Turkish lira, but as of writing this, the Turkish lira is down 0.2 percent against the U.S. dollar. This is because Wednesday was perhaps the worst day to raise interest rates in the last three months as the U.S. dollar index was at its highest level in months. The Turkish lira appreciated against the euro, the pound sterling and gold all while losing ground against the dollar. Raising interest rates is not a panacea anywhere and especially not in Turkey.
For substantial currency appreciation, Turkey needs to look elsewhere. Obviously many of the problems Turkey faces are outside of its control. Two superpowers are fighting a proxy war on Turkey's southern, eastern and northern borders. Turkey has little in the way of choices when it comes to making dents in those battles. It can only do whatever is in its power to keep the fighting at bay, but ultimately these wars will be decided by the U.S. and Russia. The U.S.'s decision to arm and strengthen the People's Protection Units (YPG), a terrorist organization the U.S. admits is merely a cover for the State Department recognized terror group the PKK, has forced Turkey to engage in war on its southern border. All of these events have taken place in the aftermath of the attempted coup in 2016 and come at a period of interest rate hikes by the Fed. These moves will almost certainly cause a flight of quality by investors globally and adversely affect access to the cheap capital emerging markets have experienced in the past decade.
Should the Fed continue its data independent decisions, rates will rise, emerging markets will be forced to raise rates twice as fast and borrowing will be far more expensive. This will hurt real economies and ultimately cause political uncertainty everywhere. For investors, it is going to be a very bumpy two years.