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Is The Tightening Cycle Over?

Since June 2023, the Central Bank of the Republic of Turkey (CBRT) has aggressively raised the policy rate from 8% to 50% in an effort to combat rampant inflation. However, in December 2024, the CBRT surprised markets by cutting the policy rate by 250 basis points (bps) to 47.5%, signaling an end to what many had perceived as an unrelenting tightening cycle.

Despite the start of an easing cycle, analysts predict that 2025 will see the central bank maintain a cautious stance, as inflation remains persistently high. While the CBRT’s inflation target stands at 21%, the latest annualized reading in December 2024 was significantly higher at 44.38% - a challenging gap to close by the year-end 2025 target. Governor Fatih Karahan has emphasized a dual approach to fighting inflation, employing both supply- and demand-side policies to meet the ambitious goals. However, market participants appear skeptical of the CBRT’s strategy.

All 25 institutions surveyed in Bloomberg’s latest poll unanimously expected the Central Bank of the Republic of Turkey (CBRT) to announce a 250 basis points rate cut during its meeting on Thursday, January 23, 2025, according to The Daily Sabah. As anticipated, the CBRT’s Monetary Policy Committee lowered its benchmark one-week repo rate from 47.5% to 45% and cut its overnight rate by an additional 250 bps during the meeting. Looking ahead, the CBRT’s next inflation report is scheduled for release on February 7, 2025. This report will be closely watched for any adjustments to the central bank’s outlook and policy framework for the coming year.

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Support for the Lira

To close out 2024, the Turkish lira hit an all-time low against the US dollar. According to Reuters, the lira has depreciated by 40% over the past seven years, reaching 35.3/USD. Analysts expect further weakening, with potential rate cuts likely to push the currency into the 38-40/USD range.

Carry Trade

A January 8th report from Bloomberg revealed that the most popular carry trade among emerging market economies over the past six months was a long position on the Turkish lira (TRY) paired with a short position on the US dollar (USD). This trade generated an average return of 15%, nearly double the next best-performing carry trade involving the Argentine peso. As with any carry trade, success depends on minimal currency volatility. Bloomberg noted that the lira’s depreciation has been relatively contained, ending 2024 with its smallest annual decline since 2020, down 16.5% against the US dollar. One of the main factors driving the profitability of the Turkish carry trade is the strategy of “Real Appreciation” explained below.

The Turkish central bank plans to further simplify its macro-prudential framework in 2025, a move that could influence the attractiveness of carry trades. Additionally, the bank intends to phase out the foreign exchange-protected Turkish lira deposit scheme (KKM) in 2025, which may significantly impact currency dynamics. The termination of the foreign exchange-protected Turkish lira deposit scheme (KKM) in 2025 could reduce the central bank’s support for the lira, increasing currency volatility.

This heightened uncertainty may discourage carry trade activity, as traders typically rely on currency stability to sustain profitability. While carry trades involving the Turkish lira remain appealing, some analysts caution that their profitability may diminish over time. A study examining USD/TRY carry trades between 2005 and 2016 found that, despite substantial interest rate differentials, profitability had been on a declining trend. Capital flows could offer further insight into the direction of the Lira ahead of the upcoming rate cuts.

Capital Flows

Since April 2024, portfolio inflows into Turkey have exceeded $10 billion, primarily driven by investments in government domestic debt securities, reflecting growing optimism about the country’s disinflationary trajectory and the stability of the lira. The CBRT has been actively intervening in the foreign exchange market, selling $23.6 billion before the March 31, 2024 elections and purchasing $41.8 billion since, with an average daily purchase of $3 billion in recent weeks.

Inflows for the first nine months of 2024 totaled approximately $7.67 billion, an 8% increase from the previous year, primarily driven by equity capital inflows and investments in real estate and services. In July 2024, Foreign Direct Investment (FDI) rose 28.7% year-on-year to $1,180 million. The industrial sector received the largest share, attracting $348 million (59.3%), followed by the services sector with $234 million and agriculture with $5 million. European countries dominated equity capital FDI inflows, contributing 79.4% ($466 million), while Asia and the Americas accounted for 8.9% ($52 million) and 11.8% ($69 million), respectively.

Meeting Inflation Targets

Capital flows in 2024 struggled to keep pace with inflationary pressures. Consumer prices rose by 1.03% in December, down from 2.24% in November, driven largely by services with time-dependent pricing and backward indexation, according to the Central Bank. While core goods inflation remains relatively low, last-quarter indicators suggest domestic demand is at disinflationary levels. The Central Bank acknowledged some improvement in inflation expectations and pricing behavior but warned that risks to the disinflation process persist. It reaffirmed its commitment to maintaining a tight monetary stance until a sustained decline in inflation ensures price stability.

Total inflation slowed to its lowest pace in over a year at the end of December, as the tightening cycle abruptly ended with rates at multi-year highs. Despite recent improvements, inflation expectations in Turkey remain above the CBRT’s targets, with 12-month and 24-month expectations at 25.4% and 17.7%, respectively. A 30% increase in the minimum wage for 2025 is expected to raise monthly inflation readings in the short term. Volatility in food prices continues to be a significant contributor to inflation, while ongoing depreciation of the Turkish lira could maintain upward pressure on import prices and overall inflation.

The Augury of Monetary Policy

Erdoğan, having been in power for over two decades, made headlines in 2021 with his remark on inflation, stating, “As a Muslim, I will do whatever our religion commands me to do. God willing, inflation will be reduced when possible.” While Erdoğan could not have predicted the future, his policies have undoubtedly influenced Turkey’s inflation trajectory over the past four years. According to the Financial Times, inflation surged dramatically in the lead-up to the 2023 presidential election as Erdoğa raised public sector salaries, pensions, and the minimum wage to secure votes. However, after winning re-election, Erdoğan reversed course, much to the relief of domestic and international investors. Last month, Scope Ratings, a credit-rating agency, upgraded Turkey, citing a sounder economic and financial management driving the replenishment of international reserves, easing pressure on the balance of payments, and reducing financial stability risks.

In addition to Scope Ratings, Turkey's credit ratings from other major agencies have seen significant improvements in 2024. On November 1, Standard & Poor's (S&P) upgraded Turkey's long-term sovereign credit rating to BB- from B+, citing the central bank's tight monetary stance, which has stabilized the lira, lowered inflation, rebuilt reserves, and promoted financial de-dollarization. Moody's raised Turkey's credit rating to B1 from B3 on July 19, marking its first upgrade for the country in 11 years, with a positive outlook reflecting improving economic prospects. Similarly, Fitch Ratings upgraded Turkey's Long-Term Foreign Currency Issuer Default Rating (IDR) to BB- from B+ on September 7, highlighting strengthened external buffers and reduced foreign exchange liabilities.

There appears to be renewed optimism on the sovereign credit side as Turkey begins easing rates amid some disinflationary trends in late 2024. However, the lira continues to weaken, and the phased-out foreign exchange-protected deposit scheme (KKM) could erode the low volatility seen in recent months. While forecasting inflation and growth with certainty would remove the need for speculation, we'll leave that herculean task to the CBRT.

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