FxWirePro: USD/TRY call spreads and CBT rate hike - a run through

Central Bank of Turkey will likely tolerate a weaker FX market pricing for rate hikes is aggressive, in our view, given the indications of weak economic growth and the rising vulnerability of the CBT to political pressures. The central bank will likely keep policy rates stable and use liquidity measures to prevent excessive TRY depreciation (out of line with other EMs). External borrowings will have to be rolled in domestic markets, putting further pressure on the exchange rate. We recommend being long a 3m USDTRY 1x2 call spread.

We recommend being long USDTRY through a 3M 1x2 call spread, with strikes at ATMF and 3.35. The option costs 0.69% (spot ref: 3.0658), with significant savings relative to the vanilla ATMF call (which costs 3.5%). The 1x2 call spread effectively expresses our view that moderate USDTRY upside is likely, given the fundamental outlook; however, sharper moves would invite a more aggressive monetary policy response.

Why call spreads - the key fundamental driving forces:

• The recent increase in TRY real interest rates and sharp currency sell-off should not be faded. First, while TRY real interest rates have kept pace with the currency move, breakevens have widened more than 100 bps and explain almost all of the increase in long-term interest rates.
   
• Second, the c.9% depreciation of the TRY versus the USD since mid-August has happened alongside broad-based weakness in EM FX. However, the TRY does not look exceedingly cheap from a medium-term perspective.
   
• Although the CBT is likely to keep domestic liquidity conditions tight, we think it will likely tolerate TRY weakness at the expense of hiking rates, considering the fragile growth outlook and increasing vulnerability of the CBT to political pressures post-Babacan.
   
• Fourth, there seems little potential for the CBT to surprise the markets, given that spot short-term interest rates are above the forwards.
   
• Finally, we reckon the simplification of monetary policy is a red herring at this stage and actual moves may have to wait until after Fed normalization.