EM Daily-Turkey:CBT reaction function begins to take shape

　　Turkey: CBT's reaction function begins to take shape; Simsek kept his position

　　The Central Bank of Turkey (CBT) lowered its O/N and late liquidity window lending rates by 50bps each to 9.5% and 11% respectively, in line with median market (and our) expectations. The Bank's main funding tool, one-week repo, and O/N borrowing rate - lower band of rate corridor - were kept unchanged at 7.5% and 7.25%, respectively. While the Bank still labels its cuts as measured steps towards corridor simplification, this is simply policy easing, in our view, to reinvigorate loan demand. The May rate decision was crucial to better understand the Bank's new monetary policy reaction under Cetinkaya. While one needs to accumulate additional sample points to reach a reliable conclusion, another 50bps cut despite the ongoing Fed re-pricing and a marked nominal depreciation in the lira supports our assessment that the CBT is en route to follow a policy path prioritizing high growth accompanied by weak (and competitive) currency, inflation at high (or close to mid-) single-digits, and low real policy rates. We think there is further (50bp) room for easing in the O/N lending rate in the coming period. For details, see Data Flash - Turkey.

　　Also in Turkey, the ruling AKP revealed much-awaited details of the new cabinet. Despite intensified market expectations for a possible departure, Mehmet Simsek, Deputy Prime Minister in charge of economy, kept his position in the government. New cabinet has defied market expectations for a grand overhaul in economy management, and hence an undue tail risk is again avoided. Despite some possible retraction in near term, political risk premium on Turkish assets however is likely to remain elevated, particularly given PM-designate Yildirim's recent remarks that his government's priority is to deliver a constitutional change to bring in executive or party-affiliated presidency in near term. For details, see Turkey: Treading with caution (for now).

　　EM curves on the move

　　Following the change in Fed’s language and recent monetary policy decisions in Hungary and Turkey, EM curves have been on the move. In South Africa, we continue to recommend receivers (via 9x12 FRAs, targeting 7.50%) with a steepening bias in money-market slope (as rate hikes are pushed out) and we also maintain the view that the curve is too flat given persistence of inflation and gradual deterioration in creditworthiness we foresee. We keep forward-starting steepeners via 3m fwd 1Y-10Y (targeting 130bp). Although we continue to see long-end bond to remain well supported we scale back from “overweight” to “modest overweight” following the recent outperformance vs. Turkey. The latter was in focus yesterday, with the easing bias and the pro-growth stance supporting our short-end XCCY receiver in 1Y (targeting 9.50%) and our recent EMEA portfolio switch to tactical “overweight” on the underperformance vs. peers. With a mix that is detrimental to inflation, we stay long inflation-linked bonds in the belly of the curve (with a new target in EM Daily: Turkey: CBT reaction function begins to take shape

　　B/E pushed up to 7.70%). The monetary policy decision in Hungary also supports our recent recommendation to buy long-end bonds given attractive risk-reward and possible upgrade. Since then 10Y bonds rallied by around 10bp while more importantly Hungarian bonds outperformed EMEA peers. The stable but low-for-long (through end-2017) monetary policy and valuation still support more flattening, in our view.

　　In contrast, monetary and FX policy have backfired in Mexico. Rather than anchoring the curve, Banxico’s hike and FX intervention actually rendered the money market curve more sensitive to US yields and the currency - which is actually trading with a higher beta to global risks. We have recommended bear-flatteners (via 1Y1Y vs. 5Y5Y) on reduced premium in light of heightened sensitivities. After the recent move we prefer to take profit as the pricing in the short-end has already overshot, in our view. We fear that, if Banxico continues to send mixed signals on all fronts (FX, inflation, and rates), the curve may bear-steepen. Also, it is possible that it may decide to intervene again and thus trigger squaring in positions. Also see Mexico Rates: Flat Enough for Now.