“Darkness at noon” or simply in darkness?
Ihaven’t been yet wedded to the idea that a double dip recession is in the making. True, calendar-adjusted MoM 8.5 percent and 7.6 percent April production contractions, in intermediate and capital goods respectively, are a lot more than March figures. Even unadjusted IP dropped by 1.4 percent annually. This shows only one thing: Q2 will probably post a negative GDP print, but we (almost) knew that, right?! The problem is exacerbated if we consider that both the budget deficit and tax revenues signal very small a margin for government expenditures in H2. After an incredibly high – above 30 percent 3-month moving average annualized - non-interest expenditure spike that lasted three months – January, February, March - expenditures dropped sharply in April and May, but so did tax revenues in May. Except favorable base effects and the oft-quoted normal business cycle ‘revival’ of some sort, there isn’t much ammunition left to shore up spending in the second half. Once again, elections are the main culprit. The budget has been by and large already spent in the first months of the year. True, one can always print money, but at the peril of triggering further dollarization and inflation. The good news is, first, inflation will enter the base effect period, and there is room for a drop all the way down to 11-12
percent in the last months of 2019 – to possibly rise a bit afterwards. Second, a Fed easing cycle may indeed be approaching, and as of now, three 25 bps FFR cuts have been priced in. This will help, perhaps more than it can be thought initially, but only if the CBRT’s rate cutting sequence isn’t prematurely initiated. All in all, I still think GDP will be negative, slightly below zero, for the year as a whole, but it will turn positive in Q3. I also think there may now be a good chance to stabilize the lira, given the Fed, and given that a reasonable political solution can be found regarding the S-400 purchase. A bit optimistic perhaps, but the alternative can be perilous for the economy at large.
To what extent can the Fed cycle help?
The odd thing is whenever there is a Fed hiking cycle looming large on the horizon, everybody jumps in, and enumerate risks for the financial account and borrowing costs, for banks and non-banks alike, including truly ours, but in the opposite case the attention isn’t symmetric. However, the graphic depicts what happened to the MSCI Turkey-EM spread after the ‘taper tantrum’. It is clear that after August 2013 there are only rare moments when Turkey fared better, and the spread opened wide in the last three years. Now that the cycle may turn, there may be a benefit, if not of an equal order of magnitude, a benefit still. I predict both Turkish debt and assets will perform better if the Fed will indeed cut the FFR thrice. If it is true that as U.S. 10-years yield rises, so does either the benchmark TRY rate or the TR 10-year Eurobond yield, then the converse is also true. The effect need not be identical, obviously. So, what is wrong with the first argument? It is this: We can’t say that as the U.S. 10-years yield rises, so does either the benchmark TRY rate or the TR 10-year Eurobond yield rise monotonically. No, it doesn’t. The keyword here is ‘monotonically’. They rise, but not monotonically.
The technical terms here are Granger causality and second-order stochastic dominance. The first refers to leadership in the sense of predictive ability – the U.S. rates are a good indicator of what is to come elsewhere. The second refers to a kind of mean-preserving behavior of the spread between any two government bonds. In other words, it must be true that when the U.S. rates go up, the compared country’s rates should also go up with very high conditional correlation and at least by the same amount. The first part is correct for many countries, including Germany, the UK, Canada, and Turkey of course, but the second argument isn’t. Still, the first argument that defines the directional change carries the day. There will be room for both TRY and Turkish Eurobond yields to fall, but not necessarily on the same day or in the same month, and not necessarily at the same rate as the U.S. 10-year T-notes. The keyword is here asset (currency substitution) that is still ongoing in Turkey. Therefore, many things are crucial, but the timing of the likely CBRT rate cut sequence is all the more important.
When is tit-for-tat subgame perfect?
Enter the S-400 and all that, again. Is there no solution ahead? Is the plane flying against a headwind or what? Are things easier than they look now? Is the polit
ical game solvable? Or is it true that ‘a little game theory’ is worse than no game theory at all? Truly, a little game theory can be a dangerous thing. There are those who aren’t only well-versed in the theory of games, but not even aware of its basic heuristics. The ill-founded “win-win” phraseology is one such example that one often encounters in the press. There are many kinds of games, and information, the strategy space, if it is a repeated game or what kind of game it is, etc. Postulating a principal-agent game admitting a “folk theorem” with respect to the subgame-perfect (Nash) equilibrium –characterized by bargaining, struggle or tit-for-tat as it happens - could be one way of capturing this idea.
Then the question becomes: Is the game a “folk theorem” game and does the equilibrium of this game entail bargaining, appropriately represented in game-theoretic terms? Indeed, if there is a (locally) unique Nash equilibrium with tit-for-tat looking features but ultimately giving way to co-optation when the rate of discount approaches one and if there is another (locally) unique Nash equilibrium without it when the rate of discount approaches zero, then the (political) game may not be a “folk theorem” game. Tit-for-tat is not continuous for all parameter values in an open neighborhood around the equilibrium and there is no game-theoretic heuristic representing the claim that such behavior always matters. Hence, which is which? Which players can wait most? Indeed, if the whole idea is about who will give up or in first, we have about a couple of weeks before the dust dissipates. I think it is a sensitive situation because what still looks tractable might easily turn into a mess. On paper, before deciding what long-term course of action to follow, Turkey has a few options still, but then the road might be bumpy. In parlor games, sometimes people “overplay” their hands. On the other hand, claiming that reconciliation between the U.S. and Turkey in the end is a distinct possibility forgets one thing. True, in the past it all boiled down to somewhat more bargaining and eventually coming to a solution. But postulating the existence of a closedloop equilibrium for political history, which is by definition independent from path, is tantamount to arguing that the political process is the unfolding and the realization of a conserved essence. This is so because in such a closed loop, history’s beginning and its end would be independent from whatever happens in between. The image of a self-regulating ecosystem seems to perfectly fit such path-independence and, if such history is not totally static, the uttermost dynamic it can admit is a linear drift. No, there may lie many non-linearities ahead and every actor may end up finding themselves in an entirely different configuration. Still, having said that, I opt for a positive unfolding of the crisis, and I impute more than 50 percent likelihood to that possibility.
If this happens, then what?
We know that the lira depreciated as a trend against the two major currencies for the last 11 years or so. The important thing to know is the timing of the depreciation cycle. Has it already depreciated too much to gain some strength now? We tend to think so on two counts. First, yes, the lira has already depreciated above trend in two consecutive years. Second, orderly and anticipated Fed rate cuts was the best the EM universe one could hope for, and it is happening.
If the lira stabilizes, and given that domestic demand will not be buoyant after the election, inflation will depend mainly on food prices. There are three major channels through which inflationary shocks occur: exchange rate pass-through, food prices and oil prices. Oil prices have already reached a certain plateau, and the lira has already depreciated a lot. Currently, year-end CPI expectations hover around 16 percent. Depending on the occurrence of a global reflationary spiral – given the “Trump trade”- that is a distinct probability. However, even better, inflation might as well stay steady at around 12-13 percent in the aftermath, or at worst it might go up a bit but not above 15 percent in 2020 unless there is a renewed currency shock. We think low two-digit inflation as a transitory phenomenon.
In the end, it would either go up or down. Now, this may look a bit far-fetched but we think fluctuations within a band of 15-16 percent expected inflation might not change an iota in monetary policy for two reasons: the CBRT may not react, at least not by cutting the policy rate, claiming – rightly or wrongly - that any possible move would be cyclical, but essentially because it may remain prudent. Of course, this is assuming no other influence will weigh unduly on any possible decision. Also, it may well fix its gaze on international financial flows much more than it cares about the vicissitudes of an inflation that anyhow is likely to remain in double digits, but at levels that are much lower than it was in H2 2018. I do know obviously that raising the policy rate is not a popular option, and that local monetary policy is biased toward easing. However, timing is crucial here. What may happen then, that is if the CBRT stays put throughout? Well, it won’t exactly stay put but the response of the CBRT to the Fed’s moves would signal at the very least that exchange rate stability is an important priority. The rest will depend on cross-border inflows, and cross-border inflows will in turn depend, assuming no bad timing in sequencing interest rate moves occur, on the relations with the U.S. As simple as that.