Faros was stopped out two carry trade ideas that fell victim to USD’s ongoing, global upsurge catalyzed by USD/JPY’s push through 100 last week. Our paper loss on a March 20th sell-USD/CLP idea was 0.99% (1.71% spot loss offset by +0.72% carry). Our loss on an April 16th sell-Basket/TRY idea was 0.91% (1.25% spot loss offset by +0.34% carry). Regarding the latter (and note that basket funding is 50% USD and 50% EUR), the implicit 50% short-EUR/USD partial hedge to a short-USD/TRY position was insufficient given EUR’s lower beta to USD moves compared to most other currencies (including TRY).

I remain favorably disposed toward re-entering both of these trades if the global USD appreciation trend is arrested.

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All 3 of the views outline above make sense, and in many ways all 3 are in play currently.  The 1st view regarding QE tapering has helped spark a backup in US yields with 10yr swaps up to 2.100% area.  However, Williams’ comments failed to push this rate through that 2.10/2.15% resistance area we have been highlighting and yields are actually cooling a bit since then.   #2 is also playing out as commodities are once again under pressure as gold and copper turn south and this has helped keep the USD elevated.  Or said another way, USD strength has prevented these pairs from rallying.  ANZ put out a good piece supporting #2 as the primary driver of USD strength as they highlight the move in commodity currencies over G10 currencies.  #3 is harder to prove and but is logically sound as a USD rally really does benefit just about everybody.

For now I listen to the tape and remind myself that you can’t argue with price action.  I flipped to AUD/USD short on the break of 0.9830 yesterday and the selling from a variety of accounts last night was intense.  I note that the 10yr swap is still failing to make new highs and yet DXY is testing the 2012 highs around 84.20.  A break here could see the beginning of a new leg in USD strength and needs to be respected.  It is also notable that USD/JPY remains bid even after the vaunted 100.00 level has fallen.  In all things markets you have to respect the tape, so for now I humbly do.  Also interesting to note that JPM is out with a 1715 SPX call for year end this year, a full 3.7% higher from here!  So much for sell in May and go away.

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Last night, Faros held a research dinner with an Istanbul-based expert on Turkish politics and economics, Atilla Yesilada. Below are selected takeaways in two categories: politics/geopolitics and economics/strategy.

Politics / Geopolitics

• Syria poses the most imminent danger to Turkish markets, with risks that are unpredictable. Sectarian violence could spread to Iraq and then Iran, with contagion to Turkey via its Kurdish problem.
  • Syria is a failed state with no constructive end game scenarios. The best outcome would be self-contained violence, but regional contagion risks will worsen the longer Syrian instability persists.
  • To date, abundant global liquidity has blocked markets’ perceptions of geopolitical risks to Turkey. Markets have every reason to trust the (ruling) AKP not to attack Syria. For now, Turkey is an oasis of freedom, stability, and prosperity. But business confidence would drop if more Syria-related attacks occur.
  • 75% of the public wants no involvement in the Syrian conflict and would politically punish Prime Minister Erdogan if he got involved.
  • Turkey’s demographics are similar to Syria’s; Turkey has 10M Alawites who are very angry at Erdogan; the AKP has prevented recognition of the Alawite faith as a legitimate religion.
  • Sectarian war in Iraq could target oil & gas infrastructure, disrupting Iraq’s globally significant 3 MBD of oil exports.
  • Erdogan has successfully befriended Iraqi Kurds, who are offering Turkey a major oil and gas pipeline project in return for a pledge of mutual defense. A twin pipeline could carry 1 MBD of oil and 10M cubic meters of gas per year. In five years, this could reduce Turkey’s current account deficit by 1% of GDP via lower energy costs and earned pipeline transportation fees.
• Peace Process vis-à-vis the PKK (Kurdish armed rebels)
  • No terror is expected in next 12 months due to the PKK’s near-term pullback into Iraq.
  • In the longer term, the peace process will not go anywhere because of a greater problem: inadequate democracy in Turkey under the existing constitution.
    • Kurds want: a new constitution with language that Turkey is a voluntary association of two peoples; a bi-lingual state; federalism; freedom of jailed PKK leader Ocalan; and amnesty for all PKK members.
    • The 10% election hurdle (needed for a party to gain seats in the parliament) completely disenfranchises 10M Alawites and 25M secularists/Kemalists – but elevates AKP’s political power.
    • Required constitutional changes would be so revolutionary – and entail such a massive change in the AKP’s mentality – that they are highly unlikely.
• Elections (local – March 2014; presidential – August 2014; general – Summer 2015)
  • Market risks: Fiscal loosening ahead of elections would render Turkish markets more vulnerable in the event of an EM risk shock. But risk of AKP losing power is very small.
  • AKP is so far ahead in the polls that it’s hard to construct a scenario in which it loses power. Thus, risk scenarios extend only to reductions in AKP’s majority / lost moral authority to rule.
    • AKP’s popularity stems from a robust economy driven by: global liquidity; adhering to IMF reforms imposed since Turkey’s 2001 crisis; and AKP’s responsible/pragmatic/excellent economic management.
    • Over the past decade, AKP has made Turkey an indispensable part of the global marketplace; AKP’s business-friendly policies are behind Turkey’s world class business class, superior among EMs.
    • A (highly unlikely) AKP loss would have a devastating impact on business confidence.
    • Erdogan almost certainly will run for president, with intent to change the constitution to increase presidential power. More presidential power would mean more stability.
    • An intra-AKP power struggle to replace PM Erdogan would occur if/when he steps into the presidency. Erdogan is immensely popular, having created a personality-cult following; no alternative personality within the AKP comes close.

Economics / Strategy

• Monetary policy
  • Currently, CBRT is not worried about inflation. [Note: this is consistent with its 50 bps cut in all policy interest rates today.]
  • There are no demand-side pressures on CPI; food prices are benefiting from a good year for crops; and global commodity prices are dropping.
  • The very popular Erdogan is effectively the “boss” of all government institutions (including CBRT) via the bully pulpit (public pressure), and he wants strong GDP growth ahead of the upcoming election cycle. Growth at faster than 4.5% implies a falling unemployment rate.
• CBRT’s FX-rate-related policies
  • TRY volatility will be kept low within a flat range of roughly Basket/TRY 2.05-2.10.
  • Appreciation would hurt already-challenged low-value-added exporters.
  • Depreciation would worsen core inflation and hurt corporates with unhedged FX liabilities
  • Uncontrolled depreciation would be very dangerous to Erdogan because voters don’t want a weak TRY and would lose confidence.
• Turkey’s banks are extremely well capitalized, with a capital/assets ratio of 12.5% under Basel II. The BSRA is a very strict regulator, and would be willing to use macro prudential measures to slow loan growth.
• Strong employment growth numbers are misleading because 60% are low-productivity, low-pay government jobs.
• Consumer wealth effects are a function of the interest rate paid on bank deposits, which are the bulk of the public’s financial assets; interest rates are low and declining.

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