Breakeven Rate Shows Inflation Goal Beyond Reach: Turkey Credit

Bondholders are losing confidence in central bank Governor Erdem Basci’s ability to meet his target of cutting the highest inflation rate among major economies in half.

While Basci says consumer price gains will slow to 5.1 percent by the end of 2013, investors raised projections to 6.9 percent March 1 from 6.5 percent on Feb. 21 as the central bank lowered borrowing costs for a second time this year, based on the gap between fixed-rate bonds and those paying returns tied to inflation known as the breakeven rate. Bets on rising consumer costs made Turkey’s inflation-linked bonds the best performers after Italy this month, according to data compiled by Bank of America Merrill Lynch.

Inflation more than doubled last year to the highest among the Group of 20 economies as the world’s biggest currency depreciation drove up the cost of imported goods. The rate probably held at a three-year high of 10.6 percent in February, according to the median estimate of three economists polled by Bloomberg before a report from the statistics office due March 5. Basci cut banks’ overnight lending rates and its benchmark one-week repo rate in the past two months, saying a 7.9 percent rebound in the lira against the dollar this year and slowing domestic economic growth had damped price pressures.

Close to ‘Peak’

“I don’t see any reason why inflation would drop quickly,” Paul McNamara, who oversees $7 billion at GAM Investment Management in London, said in a telephone interview on Feb. 27. While “we’re close to the peak in terms of inflation, all that really matters is how the lira behaves,” he said.

The two-year breakeven rate, which reflects expectations for inflation over the period, climbed to a record high of 8.76 percent on Nov. 25 as the currency plunged 18 percent against the dollar last year, data compiled by Bloomberg show. It fell to as low as 6.16 percent on Jan. 31 after Basci sought to stem the depreciation and consumer price increases by selling dollars and raising banks’ interest costs to the highest end of a corridor between the benchmark one-week repurchasing rate at 5.75 percent and the overnight lending rate of 12.5 percent.

Basci, 45, reversed that policy in January, lending mostly at the lower rate, after economists from banks including New York- based Bank of America and Goldman Sachs Group Inc., pointing to the record current-account deficit, warned that the nation’s growth rate threatened to send the economy off the rails. He then cut the overnight lending rate to 11.5 percent from 12.5 percent on Feb. 21 and kept the benchmark one-week repo rate unchanged at 5.75 percent.

Hurting Growth

The effect of the lira’s depreciation is starting to fade and inflation will slow, according to policy documents published on the central bank’s website on Jan. 31. Tightening monetary policy to accelerate the slowdown in inflation would hurt economic growth, Basci said in a quarterly briefing in Ankara the same day. Inflation will be 6.5 percent by the end of this year before dropping toward the bank’s 5 percent medium-term goal, he said.

The central bank survey of more than 80 economists and executives published Feb. 22 shows inflation at 6.9 percent in 12 months and 6.4 percent in 24 months.

“The market is less optimistic than the central bank, particularly in the short term, where pricing is much more cautious,” said Erkin Isik, a fixed-income strategist at Turk Ekonomi Bankasi AS in Istanbul. The bank’s decision to cut the overnight lending rate last month showed that “it’s getting less hawkish on inflation,” he said.

Inflation-Linked Debt

Inflation-linked bonds accounted for 13 percent of lira debt sold in January, according to the Treasury in Ankara. Turkey’s debt totals $289 billion, about 40 percent of gross domestic product and almost double Russia’s $143.9 billion, data compiled by Bloomberg show.

While Basci’s rate cuts helped spur speculation Turkey will avert a recession and sent two-year fixed-rate bond yields sliding 230 basis points this year, the most in emerging markets, the rally is starting to lose momentum. Yields climbed as much as 18 basis points from a four-month low of 9 percent on Feb. 22, the day after Basci cut rates, data compiled by Bloomberg show.

Two-year lira yields rose 1 basis points, or 0.01 percentage point, to 9.24 percent, according to an index of the securities compiled by Turk Ekonomi Bankasi AS.

The extra yield for Turkish dollar bonds over similar-maturity U.S. Treasuries rose two basis points to 325 today, compared with an average of 348 basis points for emerging markets, according to JPMorgan Chase & Co.’s EMBI Global index.

Lira Falls

The lira fell 0.6 percent to 1.7646 per dollar, paring this year’s advance to 7.2 percent.

The cost of protecting Turkish bonds against default using five-year credit-default swaps fell six basis points yesterday to 236, according to CMA, which is owned by CME Group Inc. and compiles prices quoted by dealers in the privately-negotiated market. The spread was 182 for Russia, rated three levels higher by Standard & Poor’s, 194 for Poland and 156 for South Africa.

Turkish contracts cost 30 basis points less than the average for countries in central and eastern Europe, the Middle East and Africa included in the Markit iTraxx SovX CEEMEA Index. The swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a government or company fail to adhere to its debt agreements.

Energy Prices

The central bank has warned that rising global energy prices pose a risk to inflation. The bank’s inflation forecasts are based on an assumption of Brent crude prices at an average $110 a barrel. The price has been above that level since Jan. 25 and was $123 on March 1.

Energy Minister Taner Yildiz said Feb. 28 that the government is “struggling” to stop higher oil and gas prices being passed on to homes and businesses.

Basci will probably keep his policy unchanged provided oil prices don’t threaten the broader market outlook, Turker Hamzaoglu, an economist for Bank of America Merrill Lynch in London, said in a report e-mailed yesterday.

“We do not expect a pro-active policy response unless higher oil prices tip risk sentiment globally,” Hamzaoglu said. “Tolerance for higher inflation is quite high.”

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