As Turkey's president Recep Tayyip Erdogan turned towards unorthodox economic policies that relied on ultra-low interest rates, state institutions had to constantly intervene to prop up the faltering lira, leading to depleted foreign-currency reserves, an inflationary spike, and a loss of foreign capital. The market expected a significant depreciation following the re-election of Erdogan on May 28, as investors bet that these policies were unsustainable.
The Turkish lira has weakened more than 13% against the dollar since the election, and state banks have reportedly halted dollar sales to defend it. While the weakening lira indicates a possible turn towards conventional economic policies, it raises concerns about elevated inflationary pressures ahead of local elections next year.
The appointment of former Merrill Lynch strategist Mehmet Simsek as the new treasury and finance minister in Erdogan's administration has intensified expectations of a shift towards orthodox policies and market determination of fair value for Turkish assets. Turkey's main stocks index rose 3.1% on Wednesday, extending gains since the vote to 21%, indicating confidence in the policy shift.
While the Turkish lira plunged to a record low, Turkish dollar bonds extended gains, with investors narrowing the yield spread between Turkey's dollar debt and US Treasuries. The central bank's next meeting to set interest rates is scheduled for June 22, and investors anticipate a hike, driven by projections of a change at the post of Governor.
Simsek's team faces a challenging task of stabilizing the lira and tackling the country's increasing inflation. Goldman Sachs has revised its forecast for the dollar-lira pair higher, with the bank expecting the lira to depreciate to 28 per dollar in the next 12 months. The options market is currently pricing an 80% chance of the lira falling to 25 per dollar within the next three months, with a more than 60% chance of it hitting 27 per dollar.