Putin’s Turkey

Last Week This Morning

• The 10T had a quiet week until Friday when it plunged to 2.87% as fears about a currency crisis contagion in Turkey spread
  • German bund dropped to 0.31% on Friday as well, down 0.09%
• 2 year Treasury dropped to 2.61%, but experienced less of a shock since it is so directly tied to Fed monetary policy
• LIBOR at 2.07%
• SOFR at 1.91%
• Trump tweeted that tariffs on Turkish steel would be raised to 50% and aluminum to 25%
  • Lira plunged 20%
• China announced an additional 25% tariff on $16B of US goods and vicious cycle begins
• Inflation data came in as mostly as forecasted

Turkey – Economic War?

On Friday, “President” Erdogan asked all Turkish citizens to exchange their foreign currency and gold for lira to rally the currency as part of this “economic war.”  It was a bad day.

• the lira dropped 20% on Friday and is down 40% over the last year.
• 10yr Turkish bond yields spiked above 20%, double the yields in January.
• CDS spiked to over 400bps.

We have to wonder if it’s an economic war or a personal one.

First, a layman’s explanation of how tensions have escalated between the US and Turkey.  I know even less about foreign relations than I do about interest rates, so I apologize in advance for this incredibly simplistic interpretation.

The US has been losing patience with Turkey for refusing to stop trading with Iran (from which it receives 50% of its oil), supporting Kurdish forces in Syria (our allies in the ongoing battle with ISIS), and buying missile systems from Russia.

Turkey is angry that the US won’t turn over Fethullah Gulen, an Islamic cleric living in self-imposed exile in Pennsylvania.  Erdogan accuses him of orchestrating the failed 2016 coup and wants him extradited for execution trial.

The US is demanding that Turkey release Pastor Andrew Brunson and 19 other Americans that Turkey also blames for that failed coup.  The US believes Erdogan is trying to use innocent Americans as leverage to get Gulen back.  We’ve been at a standstill.

In what felt like a totally unrelated story, Israel recently arrested a Turkish woman, Ebru Ozkan, with charges of conspiring with Hamas.  She was charged with four counts of terrorist activities, largely tied to smuggling perfume to be sold to fund Haas.  But what’s that got to do with US and Turkish relations?

At last month’s NATO meeting, Trump believed he had a deal with Erdogan.  If Trump helped facilitate the release of Ozkan, Erdogan would release the Americans.  They even fist bumped.  For real.

Trump delivered.  Ozkan was put on a plane back to Turkey…but then Erdogan changed the terms of the deal.  Now, he also wanted the US to grant clemency to a Turkish bank and one of its officials accused of violating US sanctions on Iran.

This is purely speculation, but I suspect this is when it turned personal for Trump.  He thought he had a deal to bring home innocent Americans and Erdogan snubbed him.

If it really did just get personal, then we have to consider the possibility that Trump will use the US’s considerable economic leverage to punish Turkey.  And if it is truly personal, then downside scenarios could be exacerbated.  That is why Friday’s market response was so dramatic.

While Turkey’s economy has been struggling, it hasn’t been in a death spiral.  But over the last year, red flags have been thrown up as Erdogan turned increasingly more autocratic.  Last month, Erdogan declared himself in charge of setting interest rates, not the central bank.  Not a good sign for global markets interested in free markets.

As the self-appointed “enemy of interest rates”, Erdogan seems unlikely to raise interest rates to fend off rising inflation.  Last year, Turkish inflation was 10%. Today, it is 15%.  The central bank’s stated goal is 5%.

With the sharp loss in value for the lira, Turkish corporations that took loans borrowed in foreign currency will require more lira to repay them, likely dragging those companies down.  The dollar strength will only continue as the Fed continues hiking rates, making investment here more attractive relative to emerging markets.  And as we noted above, half of Turkey’s oil comes from Iran, so the sanctions imposed there will likely flow through to the Turkish economy as well.  It is not hard to envision a scenario where Turkey is in a recession in the near future.

If Turkey continues to decline, it may be forced to seek aid from the IMF…which the US could effectively veto.

In a Sunday New York Times opinion piece, Erdogan warned that “Failure to reverse this trend of unilateralism and disrespect will require us to start looking for new friends and allies.”   While this obviously means Russia, don’t forget that Turkey’s biggest trade partner is China…have US and Chinese relations been in the news recently?

Just last week, we wrote that rates could rise in the second half of the year if we could avoid things like “Trade wars.  Geopolitical (cough cough Italy).  Currency crisis.”

If Trump and Erdogan are in a personal grudge match, the situation could deteriorate rapidly as tariffs and tweets escalate.  Trade wars.  Geopolitical risks.  Currency crisis.

Why Does This Matter?

Turkey isn’t part of the Eurozone, doesn’t use the euro as its currency, isn’t a member of the ECB, etc.  So why does this matter?

The Financial Times reported that the ECB is concerned about lending exposure from European banks, including BNP Paribas and BBVA.  As we noted earlier, Turkish corporations that borrowed in a foreign currency like the dollar or euro will struggle to make payments.  If your debt service spiked 40% in one year, would it impact your business?

According to the same report, the ECB believes that about 40% of Turkish loans are in foreign currency.  More than $200B is in dollar denominated debt alone.

As Erdogan exercises increasing control over all aspects of the country, it seems plausible that default on these loans becomes his leverage in negotiations with the US and IMF.  He reminds Trump that he can look for new friends like Russia and China to help sustain him.  And since so much of its oil comes from Iran and Russia, it is better positioned than most to escalate this economic war.

That doesn’t mean he can win, but it does mean he can exact a toll on foreign powers without losing control of the government.  He has survived a coup before, he probably believes he could survive another one.

It’s entirely possible that Erdogan is inviting this economic war.  He wants this war.  Turkey will endure a few years of economic hardship while he detaches from Eurozone/IMF/US reliance, but knows that China/Russia/Iran/India will be there to prop him up and provide enough market liquidity to survive.

The Turkish companies that fall in line and willfully default on foreign debt will be rewarded with their own bailouts.  This creates an incentive structure to look to Papa Erdogan for help and less reliance on outsiders, further cementing his control.

Foreign lenders could be on the hook for huge losses on loans to Turkey.  Currency crisis.  Destabilized markets.

And that’s why it matters.  And why Friday’s market response was so strong.  Flight to safety.

And the cynic in me can’t help but wonder if Putin has quietly orchestrating this behind the scenes…

This Week

Pretty light week on the data front, which probably wouldn’t have mattered much anyway given the situation in Turkey and escalating tensions with China.