Turkey sets dovish tone for emerging central banks

August 10, 2011

Amid widespread shock over Turkey’s interest rate cut  last week, there were a few who felt the move might just make sense. With economic growth collapsing in the West, the developing world will take a hit sooner or later — in such an environment lower interest rates are usually a good idea. So with a  global financial market rout under way, many more emerging policymakers could be contemplating following Turkey’s example.

One central bank has already done so — Pakistan on Saturday slashed  interest rates by half a percent. That surprised analysts there, all of whom had predicted unchanged rates, given inflation is running above 12 percent. Now there is speculation Israel,with its close economic ties to the United States, could also be forced into a rate cut later this month.  Policymakers in other emerging economies that are midway through the rate tightening cycle are backpedalling on prospective  increases — South Korea’s central bank, which some had predicted would tighten policy later this week, said on Tuesday it was putting rate hikes on ice. Markets have “changed dramatically,” its governor told parliament.

Manik Narain, emerging markets strategist at UBS says that while inflation is still an issue for many developing countries, safeguarding growth — and exports via a cheap currency —  is becoming a bigger priority.

“After Turkey, any stigma associated with cutting rates has been removed,” Narain says.  “Across the board we are seeing rate rise expectations getting pared back.”

That is reflected in interest rates swaps, used by investors to bet which way rates will go. In many countries the front end of the swaps curve is steadily moving lower. That  implies lower interest rates, including in countries that until last week were expected to tighten policy. Markets have this week started to signal rate cuts in Korea and Thailand for instance while in India, South Africa or the Czech Republic they have scaled back the extent to which rates could rise. Czech swaps are now pricing in 60 basis points in rate increases over the next year, compared to expectations of 100 bps just last week, Narain noted. South African front-end swaps too have collapsed, indicating a mere 25 bps in rate rises over the coming year. Last week they had forecast 85 bps.

In Latin America, the picture is similar. Chilean swap rates are now pricing in a 50 percent chance of a 25 bps cut until year end, JPMorgan analysts say, pointing out that until recently they had predicted one more hike by end-2011. Brazilian swaps too are now pricing in rate cuts over the 1-year horizon while in Colombia swaps have reduced the amount of hiking that’s priced in,  JPM noted

What that spells is weaker emerging currencies as the world tips back into currency war.  But  investors’ love affair with local emerging bonds should continue. And provided the developed world doesnt slip back into recession, emerging equities should also get some support.  But the strategy will not work for everyone — Turkey’s rate cut flies in the face of its own overheating economy and that has triggered a meltdown on stock, bond and currency markets.

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The market’s opinion on Turkey’s unorthodox monetary policy moves looks to be turning as global growth forecasts are revised down.

Just witness Societe Generale’s head of emerging markets strategy Benoit Anne’s mea cupla in his latest note:
“On that note, I guess I need to apologize to the Central Bank of Turkey which on many occasions had been the object of my sarcasm over the past few months: the Central Bank of the Republic of Turkey is actually at the forefront of policy-making in the emerging-markets universe. And I bet some other central banks will follow suit with rate cuts in the pipeline.”

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