Fed takes action

Two-and-a-half years ago, the U.S. spread between 10-year and 2-year notes stood at 0.16; now it is 0.72. The spread was 1.29 in the first week of October. As the spread widened, the Turkish secondary market benchmark and the US-10 became more correlated.

The U.S. yield curve itself shifts up as the timing of rate increase approaches. The rate hike cycle will begin in March. As usual, the Fed is expected to move step by step, i.e. 25 basis points increases each time.

Moreover, not only will asset purchases end, but the balance sheet itself will begin to shrink. This means that the Fed will sell Treasury securities to the market and liquidity will dry up.

This is expected to happen in H2 2022. The balance sheet is near USD 9 trillion. The Fed may unwind it down to the pre-pandemic level of USD 4.5 trillion. This will be a huge move that will spread over the two consecutive years.

Caeteris paribus, TL-denominated government securities’ yields, and Turkish Eurobond yields will rise, but not necessarily on the same day or in the same month, and not necessarily at the same rate as the US 10-year T-notes. However, now that the number of average expected Fed rate hikes has jumped to 4.3 in 2022 alone, US 10-year notes may rise above 3% by the end of the year. This is bad news for Turkish fixed income securities.

The claim that the TL will appreciate in the coming months looks more and more unfounded. Reverse asset substitution is improbable. There have to be signs of a radical policy change. Large FDI and portfolio investments are required for this. Swaps won’t do the trick. The old inertia coefficient (Hurst coefficient) representing currency (asset) substitution stood at over 0.60 in 2001, and the FX deposits/M2 ratio was slightly below 60%. We stand at 61% today.

Compared to the immediate aftermath of the 2007-08 Global Financial Crisis, Turkish banks and total funding will be more prone to financial and monetary policy spill-overs. Banks are more integrated to the world and are therefore more vulnerable.