Lira Carry Drops Ball as Losses Mount Before Vote

Investors who bet on lira bonds using the carry trade this month are suffering as the currency slides to the weakest level since March elections before Turkey’s presidential vote.

Borrowing in dollars to fund purchases of lira debt lost 0.6 percent in August, more than any complete month since January, data compiled by Bloomberg show. The exchange rate’s one-month historical volatility climbed 58 basis points in the period to a four-week high of 8.77 percent yesterday, exceeded only by the ruble and rupiah among 24 emerging markets.

Lira assets are starting to fall out of favor as conflicts rage in Iraq and Syria to the south, Armenia to the east and Ukraine across the Black Sea. Investors are waiting to see how Prime Minister Recep Tayyip Erdogan, who has pressured the central bank to lower interest rates, will wield power if he wins the nation’s first direct presidential elections on Aug. 10. Turkish bonds posted the biggest losses in emerging markets this week after inflation unexpectedly accelerated.

“The good performance of carry trades was bound to come to an end,” Thu Lan Nguyen, a Frankfurt-based Commerzbank AG strategist, said by e-mail yesterday. “The lira is suffering a little more than other emerging-market currencies because of local developments, but mainly on the monetary policy side of things.”

The currency may weaken to 2.24 per dollar by year-end, according to Nguyen. It lost less than 0.1 percent to 2.1595 by 5:42 p.m. in Istanbul.

Carry Trade

Turkish debt lured overseas cash after policy makers more than doubled the main interest rate in January, helping spur carry returns of 6.7 percent in the first half, the most in emerging Europe and Africa. The trade involves borrowing in countries with lower interest rates to invest in higher-yielding assets.

Carry-trade gains picked up after municipal elections on March 30 gave Erdogan’s Justice and Development Party victory, quelling months of concern that the prime minister was losing his grip on power amid a corruption probe implicating the government.

The yield on two-year government notes fell as low as 8.11 percent on July 16 from a 2014 high of 11.6 percent in March. It has surged 121 basis points since last month’s trough to 9.32 percent today as tension escalated in neighboring countries and data showed the U.S. economy is improving, boosting the case for phasing out monetary stimulus.

Risk Aversion

“Turkey is likely to remain vulnerable to further risk aversion and unwinding of carry trades,” Esther Law, who helps oversee $8 billion as a money manager at Pioneer Global Investments Ltd. in London, said by e-mail yesterday. “The volatility on the Turkish lira in the past few days is triggered more by external factors, especially the heightening of geopolitical risk in the region.”

Militants calling themselves the Islamic State have seized large swathes of northern Iraq, while NATO said yesterday there’s a risk of Russia sending troops into Ukraine under the “pretext” of a humanitarian mission. The United Nations sought to ease tension between Armenia and Azerbaijan this week after at least 19 troops were killed in skirmishes between the two former Soviet republics.

Political Transition

Presidential elections at home are also playing a part in the turn in sentiment, according to Societe Generale SA. Until now, the president has been elected by parliament and largely performed a ceremonial role. Erdogan, who has ruled Turkey for more than a decade, aims to increase the power of the presidency as Turkey approaches the centenary of its founding by Mustafa Kemal Ataturk.

“The market is concerned about the uncertainties inherent in the transition,” Phoenix Kalen, an emerging-market strategist at Societe Generale in London, said in e-mailed comments yesterday. Investors want to know “whether Erdogan will seek to consolidate power further, and whether there will be accompanying personnel changes in the political leadership.”

The prime minister has called for deeper interest-rate cuts to stimulate the economy even as inflation exceeded 9 percent for a fourth month in July. Turkey’s central bank has lowered the one-week repurchase rate by 1.75 percentage points in three cuts starting in May.

Policy makers are likely to “yield to Erdogan’s pressure to cut interest rates to stimulate growth, even though inflation risk is mounting,” Amy Yuan Zhuang, senior analyst for Asia at Nordea Markets in Copenhagen, said in an e-mailed note yesterday. “In the coming three months, we expect a weaker lira.”

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