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The Central Bank of Turkey lowered its one-week repo auction rate by 325bps to 16.50 percent during its September meeting, following 425bps in July as the inflation outlook continues to improve amid a moderate recovery in economic activity. Inflation dropped to 15 percent in August and is expected to fall briefly to single digits in October.
The cut was not as large as some market participants had begun to fear, hence the lira rallied initially. But, the outcome strengthens our view that the central bank is following President Tayyip Erdogan’s orders, and not fundamentals.
We remain pessimistic on the lira outlook and forecast USDTRY to (indicatively) reach 7.00 by the end of this year.
It is a little surprising that EM FX vols have under-reacted so severely to the bearish global impulses that have been in train all year. The net outcome of the drop in Global PMI (vol +ve), USD TWI strength (vol +ve) and fall in US real yields (vol -ve) should have been to push a VXY-EM weighted basket of 1Y ATM vols 0.5 %pts. higher y/y (-0.8 to +1.8 the +/- 1 s.e. range); the actual outturn has been a 2.3 vol pt. decline.
The degree of this under-reaction looks even more severe if TRY is excluded from the EM basket on grounds that last year’s sell-off in the lira is too extreme a template to judge other EMs, since it further weakens any justification for mean- reversion lower in vol from 3Q18’s elevated levels.
EMEA EM on average screens cheap in our BEER FV framework. The simple average deviation from our fair value estimates is now -2.6%. Excluding TRY, EMEA EM is on average 1.5% cheap (refer 1st exhibit).
Trade tips: Capitalising prevailing price dips, we reckon that it is the ideal time for deploying longs with a better entry-level, on hedging grounds 3m USDTRY debit call spreads are advocated with a view to arresting upside risks. Initiated 3m 5.50/6.24 call spreads at net debit. Thereby, one achieves hedging objective as the deep in the money call option with a very strong delta will move in tandem with the underlying spikes.
The rationale for the trading: Please observe that the above technical chart is also clearly indicating the further upside risks.
It seems that hedgers of TRY are positioned for the upside risks on the above fundamental factors. The positively skewed IVs of 6m tenors are bidding for OTM calls strikes up to 6.36 levels (refer 2nd exhibit).
IVs of this underlying pair is also on the higher side, trending highest among the G20 FX space. Call options with a higher IVs cost more, because, increasing IV is conducive for the option holder, just for an intuition that the higher likelihood of the market ‘swinging’ in holder’s favour.
