Turkey: I Expect You to Die, Mr. Bond
I remembered this famous scene when Turkish bonds rallied strongly after the favorable March inflation release on Monday. My precautionary stance towards bonds stems mainly from my belief that markets seem to have been fooled by the inflation figure, whereas supply and demand dynamics paint a mixed picture for bond prospects.
While inflation fell below 4 percent for the first time in four decades in March, the inflationary outlook is anything but comforting.
For one thing, the March reading is largely due to the unusually low food inflation. But the volatility of both global and domestic food prices have increased substantially, which means that upward surprises are equally likely in the coming months. Besides, if the past is any guide, Citi Turkey economists show, in a recent report, that unusually low food prints are reversed in the following five months.
Oil prices are another risk to inflation. Moreover, with demand going strong, producers are likely to be able to pass on the increase in producer prices to consumers. Therefore, the growing wedge between producer and headline inflation is likely to close in the direction of the headline figure.
Besides, as the same Citi report illustrates, we have always seen inflation accelerate after elections, as much-needed administrative price hikes are frozen until then. With rumors that electricity price increases are on the way, I don’t see any reason to believe this time would be any different.
I have quantified these arguments into a time series model, the details of which can be seen at my blog, as even the mention of acronyms such as VAR and VECM are bound to scare my few readers away. At the end of the day, I am left with an end-year inflation forecast of 7.5 to 8 percent.
Once you accept this inflationary outlook and 2 percent as the real interest rate, two-year benchmark bonds look, if anything, overvalued. If you work with the inflationary expectations two years ahead instead, the benchmark seems fairly valued.
Supply and demand dynamics
On the domestic demand side, banks could be hit with new reserve requirement ratio hikes, which would curb their appetite for bonds. Besides, the limited appreciation potential for the lira constrains domestic demand for bonds as well.
As for foreigners, despite the fault lines of the Turkish economy I have discussed many times, such as the current account deficit and the unsustainable growth path, investors have an extremely positive perception of the political and economic outlook.
Besides, while domestics look more to the level of the lira in whether to invest in bonds, foreigners care more about its volatility. As I expect a more stable lira before the elections, the second quarter could mark the return of the carry-trade to Turkey. Bonds would be the main beneficiaries of such flows, as the Central Bank-induced volatility has made short-term assets risky.
On the supply side, the debt stock is likely to fall to 43 percent of GDP by year-end, and the redemption schedule is rather light, with the exception of May, August and November. The positive public debt outlook and financing schedule are bond-positive, and along with a surge in foreign demand, could lead the benchmark towards 8 percent. But I would expect such rallies to be transitory, as rate hikes after the elections have only partially been priced.
At the end of the day, while I do expect them to die sooner or later, there is still hope for Turkish government bonds, at least in the short-term. After all, they, like 007, just refuse to be a good boy and die.
Emre Deliveli is a freelance consultant and columnist for Hürriyet Daily News & Economic Review and Forbes as well as a contributor to Roubini Global Economics. Read his economics blog at http://emredeliveli.blogspot.com.
Originally published at the Hurriyet Daily News & Economic Review and reproduced here with permission.
One Response to “Turkey: I Expect You to Die, Mr. Bond”
Please note that I have two addenda over at my blog: One where I sketch my empirical methodology ( http://emredeliveli.blogspot.com/2011/04/addendum-to-tomorrows-hurriyet-column.html )and another one with general comments ( http://emredeliveli.blogspot.com/2011/04/addendum-to-hurriyet-column-i-expect.html ).