We have extensively documented the ongoing collapse of Turkey's financial system in the last few days as Reserves plunge, credit risk soars, and the currency plummets...
...but Bloomberg macro strategist Mark Cudmore warns this is far more than just a 'Turkey' issue:
"The extraordinary stress currently seen in Turkey’s lira funding market may appear to be a niche issue, but the repercussions will be far-reaching."
Many commentators expressed surprise or even disbelief that ructions in the lira swap market caused knock-on effects from Sao Paulo to Jakarta. Yet the transmission is real. And it will persist, thanks to value-at-risk (VAR) limits and volatility targeting
Due to recent policy measures making Turkish lira funding prohibitively expensive -- one-week lira implied yields closed at 280% Wednesday -- it’s become almost impossible for many foreign investors to sell the lira.
This isn’t just about making it too expensive for short-sellers to borrow the currency. The problem also applies to those who are long lira and wish to exit their positions; they are trapped as it’s too costly to unwind their FX swaps.
This lack of liquidity has effectively prevented the lira depreciating even more significantly. But this isn’t a sustainable equilibrium, as VAR metrics and risk departments will be screaming to cut Turkey exposure.
Illustrating the pressure for exodus: Wednesday was the worst session for the benchmark equity index since July 2016 and Turkey’s bonds have also been walloped.
The contagion comes from these long lira positions that are essentially stuck. If funds don’t want to pay the cost to exit, the Turkey-induced jump in VAR measures force them to reduce positions elsewhere.
This mainly applies to EM funds, given that Turkey’s well-known challenges would have kept away a broader set of investors.
Local Turkish elections are looming, and there’s speculation that funding rates will subside once they are done, allowing investors an easier exit.
The anticipation of how things will play out can be seen in one-week lira volatility, which is at 53% today, up from 9.4% a week ago. (Moves have been exacerbated as some attempted to start covering lira exposure through options).
This creates a feedback loop. The jump in volatility bets based on expectations of a looming exit causes a secondary impulse to feed through to VAR and volatility-risk metrics, putting yet more pressure for investors to reduce positions.
And there’s a longer-term wave to this as well. Turkey has a large weighting in various EM bond indexes. So passive funds are staying invested for now. But what happens when retail investors see the size of their losses on this exposure?
Longer-term, the consequences of declining lira trading liquidity may spur views on Turkey’s membership in EM bond indexes.
This Turkey story is big enough that all global investors should get on top of what’s happening. Lira swap and volatility tickers will soon be on Bloomberg launchpads globally