Lira and the vicious cycle of easy money
At first sight, one would think the Turkish Central Bank has indeed “won” the battle to protect the Turkish Lira. Indeed, having fallen by 18 percent against the U.S. dollar in 2011, the lira has gained nearly 8.5 percent this year – a remarkable bounce that even prompted comment that the Central Bank might intervene in the opposite direction if the trend continues.
Unfortunately, the “lira victory” narrative is superficial to say the least. What happened was simply Turkey getting its share from rising global risk appetite.
In January alone, inflows into emerging market (EM) equity funds totaled $11 billion, according to RCB Capital Markets data – hence the spectacular rally at the Istanbul Stock Exchange.
According to latest available weekly data from the Central Bank, foreign investors bought $75 million of equities, while selling $433 million worth of government bonds – offset by Turkish banks moving in to buy bonds, emboldened by the improvement in liquidity conditions at home and abroad.
The source of this improvement is to be found in the West, as two key factors came into play: The unprecedented Long-Term Refinancing Operation (LTRO) auction in December showed investors that the European Central Bank (ECB) is ready to provide cheap money whenever needed. Many analysts agree that the timing could not be better, as the net 200 billion euros that entered the euro system prevented a total freeze-up of credit lines.
The second factor is the U.S. Federal Reserve’s explicit commitment last month that interest rates will remain at near-zero until at least the end of 2014. Fed policy makers also seemed ready to engage in a new round of “quantitative easing” (QE) if necessary.
What we’ve seen for the past few years is that as these two major central banks expand their balance sheets, investors who seek yield engage in all sorts of “carry trade” and money flows into EMs. Thus, EM policy-makers are getting more than a helping hand from their Western peers in their efforts to find a balance between economic growth and the need to “correct” structural imbalances. Of course, from another perspective, this may look like a troubling dependency on easy money policies.
Focusing on this relation in a Feb. 6 analysis, Richard Kelly of TD Securities has reached interesting conclusions. His study elegantly proves that growth in the Fed’s balance sheet is positive for EM currencies. However, since 2009, growth in the ECB balance sheet has had the opposite effect on EM currencies, displaying the rising concern about the eurozone.
Thus, if the correlation holds, the second LTRO auction at the end of this month will be negative for EM currencies, maybe triggering unrest in the markets that could in turn spur a third round of QE from the Fed, which would then help stabilize EM currencies!
“Liquidity giveth, and liquidity taketh away,” Kelly says. “EM foreign exchange markets seem likely to remain chained to the balance sheets of the Fed and the ECB until a sustained recovery and rate hike cycle can begin.”
And that depends on much more than praying for capital inflows or currency bets.