What’s cooking in exotic pairs? Hung parliament in Turkey

This is a crucial week for Turkish politics, which adds to the risk off sentiment already imposed by developments in Greece: the new parliament speaker is set to be elected by middle of the week, and this will be followed by President Erdogan formally asking AKP leader Davutoglu to form a coalition government, which in turn, will kick off official coalition negotiations.

Meanwhile latest CBT data explain constant decline in FX reserves, driven by:

Less proceeds from exporters

Constant sizeable FX auctions by CBT to fight lira volatility

In May, CBT sold $830mln via FX auctions and this amount is likely to have increased in June as the CB had to sell more FX in the aftermath of the elections.

On the export front, we also have guidance from the government that performance was dismal in June (partly because of auto strikes).

In summary, even during a good year when the current-account deficit narrowed significantly, the CB has been steadily losing reserves trying to cover for external imbalances. The developments support our view that CBT will have to tighten rates by 150bps later this year when the Fed begins to tighten.

We look ahead to increased volatility in TRY in coming months, but a calmer picture once rates have been raised - we see USD-TRY at 2.75 by end-2015.

As we pointed out last week, most EM currencies have shrugged off the Greek impasse, but escalating US rate hike fears will pose a more serious threat to high-beta EM currencies such as the ZAR, TRY, TWD & BRL.

Option Strategy Roundups:

Buy 1M USD/TRY 2.6650 - 2.6909 call spreads; longs on 5M USD/TWD 30.80 - 31.40 call spread; Buy 2M USD/BRL 3.10 - 3.25 call spread; Buy 30-Sep GBP/NOK 12.7-13.2.