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Global Foreign Exchange Research



APRIL 29, 2010

FX Insights

Receive 1y TRY cross-currency swaps

Olgay Buyukkayali Front-end receivers have been a common theme for us in 2010, where
+44 20 7102 3242 we extract risk premium. We first recommended a ZAR 1y1y in 4Q09, later recommending a TRY 1y1y, before seeing opportunity in PLN 3y.
We took profits in all these trades lately. Turkish markets have
understandably been volatile ahead of the central bank implementation
of exit strategies, but we believe volatility will calm soon.
Our macro outlook for Turkey can be summarized as: 1) a slow but
steady recovery, although a quarter-on-quarter slowdown looks likely in
Q3 and Q4; 2) inflation is not a problem, with core likely to remain
range-bound at current levels; 3) TCMB is catching up with the curve; 4)
the current backdrop requires tightening to come in 25bp steps we
expect the first in June and a cumulative 125bp in 2010, with a further
100bp through 2011; 5) signs from TCMB suggest it will not attempt a
hasty exit, but will make a more credible, gradual effort.
The Q2 inflation report has been released, so April inflation is the next
risk. Once this passes, we expect Turkish rates to experience a period
of relative tranquillity and rally.
A hawkish inflation report prospects, increasing downside risks on
European growth, and recent good news on Turkish inflation (much
more relevant for the summer) mean that the risk premium priced into
the Turkish curve (310bp in 1y) is well above our forecast for hikes we
expect over the next 12 months (we expect 150-175bp hikes; 125bp
between now and year-end).
Our recommendation is to receive 1y TRY cross-currency swaps (fixed
TRY, floating 3m USD libor) at 7.90%. We allocate US$3k/bp in our
model portfolio and intend to double the position after the April inflation
report on 3 May. The initial level to re-asses would be implied yields of
6% in 9m, which we believe we may see within three months.
In our view, the market is prepared for a poor inflation number on
Monday (our forecast is 0.25bp below consensus). Furthermore, cross-
currency swaps ultimately are a function of off-shore FX forward activity.
If inflation spikes up hard (against our base case), and TCMB needs to
bear its hawkish talons (again, not our base), we would likely see TRY
outperform significantly and the rate hike expectations feeding into the
1y implied rate are unlikely to be delivered.
Another supportive factor is that 1y swap receivers have proven to be
good trades in all the markets close to the start of the hiking cycle that
is, Australia, India, Norway and Israel. We do not expect Turkey to be
an exception.
On the currency, we continue to recommend TRY versus ZAR (see Exit
strategies in EEMEA: Buy TRY/ZAR, 6 April 2010)

Any authors named on this report are research analysts unless otherwise indicated.
Please see important analyst certifications and important disclosures starting on page 4.
Global Foreign Exchange Research

We have signalled on numerous occasions our preference for 1y cross-

currency receivers as a way of investing in Turkey given our view of the
macro backdrop.
1. Still a jobless domestic demand recovery. We have argued that
despite buoyant survey-related data, developments in unemployment,
earnings and credit markets point to 4.4% GDP growth in 2010 and only
125bp of hikes in 25bp increments (see Still a slow jobless recovery, 23
April 2010)
2. Do not expect a hasty exit. TCMBs rhetoric, the pace of monetary
exit strategies so far and with regional central banks holding rates well
below forward-looking Taylor Rule-implied levels, suggests to us that an
aggressive exit would not be optimal. We expect Turkey to make its first
hike in June and policy rates to remain below Taylor rule by 150 bp at
end-2010 and 75 bp below Taylor rule at end-2011
Inflation report observations
1. Current rates some time; low for longer. We expect the MPC
rhetoric to be repeated, meaning the tightening cycle will be
implemented in small 25bp steps, unless pricing behaviour
2. Inflation forecasts adjusted for 2010; less so for 2011. Inflation
forecast midpoints of TCMB are revised up for 2010 by 1.3pp
(higher than our estimates) to 8.4%, and by 0.2pp higher to 5.4% for
2011. We believe the 2010 revision and the Banks insistence on
expectations management support our thesis of 25bp moves.
3. TCMBs baseline scenario sees hikes in 4Q and single-digit
rates for the foreseeable future. Clearly this is later than our
expected timeframe, but do admit there is a possibility that TCMB
moves pre-emptively, with an earlier 25bp move, which would curb
inflation expectations.
1y cross-currency swaps price in an aggressive path
1y cross-currency swaps prices the terminal rate to reach 9.35% in 12-
months (Figure 1). Compared to the current overnight rate, the strip
prices in 430bp, compared to 1m (a better comparison, in our view)
which prices in 310bp of hikes. Our forecast for rates one year ahead is
8.00-8.25%, or, 150-175bp above the current level.
Furthermore, the 1y cross-currency swaps ignore the fact that FX
forwards for every other currency in EEMEA that is in a hiking cycle

Figure 1. Turkey strip Implied by cross currency Figure 2. 1Y swaps in countries that hiked rates
swaps (O/N equivalent) before cycle and current
First hike Oct-09 Oct-09 Aug-09 Jan-09
8.50 Cumulative hikes 125 bp 50 bp 100 bp 50 bp
8.00 1y swap 2weeks before first hike 5.66 2.67 2.05 5.1
3m libor 2 weeks before first hike 3.39 1.88 1.14 3.3
6.50 Risk premium before cycle (bp) 227 79 91 180
6.00 current 1-year swap 5.75 2.65 2.29 4.84
change in 1-year swap (bp) 9 -2 24 -26
O/N 1m 2m 3m 4m 5m 6m 7m 8m 9m 10m 11m 12m

Source: Bloomberg, Nomura Source: Bloomberg, Nomura

INR swaps do not get fixed versus a local labor and we used O/N
index for comparison purposes

Nomura International 2 April 29, 2010

Global Foreign Exchange Research

have settled below the policy rate. Hence, taking that into account, for
the overnight equivalents to reach this path, TCMB would need to
embark on an even more aggressive hiking cycle in the region of 450-
500bp for the receive 1y cross-currency swap trade to not provide a
If we are right about inflation, 1y rates should fall
We see the CPI at 0.6% m-o-m in April and at 6.6% y-o-y at end-2010.
These are below consensus, and we expect core inflation to remain
tame. Admittedly risks are on the upside for both forecasts, but largely
due to one-off factors. Recent efforts by the government to allow meat
imports ought to remove on a point of sticky drag on inflation.
... if we are wrong, expect carry trade flows
If our assessment is wrong about very tame domestic-demand driven
inflation, TCMB will need to be more hawkish and potentially hike earlier,
or by more making divergence in EEMEA even greater and attracting
more capital flows. Historically that has resulted in 3m and 6m implied
rates on FX forwards collapsing. We have no reason to believe this time
will be any different.
Receiving 1y ahead of hikes has proven profitable
Looking at the experience of emerging markets that have embarked on
hiking cycles this year Australia, Norway, Israel and India the 1y
swaps have not moved much during the cycle. We note that all markets
offered sufficient risk premium (similar to TRY currently), and months
after the hiking cycle the 1y is within 25bp of the level at the start of the
cycle. This trade exploits a big risk premium on the curve and we expect
the same to be true of Turkey.

Nomura International 3 April 29, 2010

Global Foreign Exchange Research

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