Euro-to-Dollar Rate Wrong-footed as Turkish Lira Tumble Warns of Currency War, Questions Outlook

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The Euro-to-Dollar rate tumbled Friday in moves widely attributed to rising geopolitical tensions, risk aversion and profit-taking ahead of the weekend, although losses could build next week and volatility increase if the Turkish Lira's latest tumble is indicative of another another currency war brewing. 

Europe's unified unit was tumbling alongside other major currencies while the Dollar Index was lifting higher ahead of the weekend, with moves dating back to overnight announcements from the White House confirming bans on some Chinese technology firms from the U.S., which may have soured risk appetite. 

"We have recommended a short EUR/USD trade idea to reflect potential downside risks for EUR which is overdue a correction lower. It is not without risks though given it is not yet clear cut that the relentless USD sell off has run its course," says Derek Halpenny, head of research, global markets EMEA and international securities at MUFG. 

China threatened retaliation against the White House before tensions rose further in the European session as the U.S. Treasury imposed sanctions on 12 Chinese officials including Hong Kong chief executive Carrie Lam, citing a so-called national security law that enhances Beijing's presence in and control over the city at the expense of freedoms and choices for Hong Kongers. 

U.S.-China tensions flared amid a fresh U.S.-Canada trade dispute but not by enough to meaningfully trouble stock markets in either Europe or the U.S., which left the Euro-to-Dollar rate's -0.8% decline appearing incongruous with the earlier tight correlation between it and the S&P 500. 

Above: Euro-to-Dollar rate shown at daily intervals alongside EUR/TRY (orange line, right axis).

"The risk of a new implosion in Turkey could weigh on market action over the coming week. EUR/USD keeps TRY(ing) to break higher but an escalation in the TRY sell-off could prove to be a short-term game-changer for both EUR/USD and risk assets," says Andreas Steno Larsen, chief FX strategist at Nordea Markets. "When USD/TRY sniffs, the EUR often catches a slight cold. The authorities in Turkey are trying to make it as expensive as possible to bet against TRY (offshore O/N rates reached >1000% on Tuesday). This is a classic boomerang beggar-thy-neighbour policy from the Turkish authorities, which should rather focus on incentivising TRY longs instead."

Europe's single currency has not fallen to such an extent as it did this Friday since July 31, which was also the last time the USD/TRY and EUR/TRY exchange rates corrected lower in the same way they did again this Friday.

"After the crazy spike in overnight implied yields earlier this week suggesting a fight against TRY shorts, rates have normalized even as the price action has picked up to the downside. No headlines or statements accompanied the move, which simply looks like a surrender. EM selling picked up elsewhere today, suggesting some contagion here, but perhaps only ZAR showing a noteworthy move to local lows against the greenback (although challenging all time lows versus the euro today)," says John Hardy, head of FX strategy at Saxo Bank. 

Turkey's Lira clawed back lost ground Friday, keeping alive August's improved correlation between USD/TRY and EUR/TRY, but was slipping again into the European close as earlier advocates of a continued EUR/USD rally dialled down enthusiasm for the Euro.

This is after USD/TRY surged Thursday amid speculation that authorities had abandoned efforts to prop up the ever depreciating Lira, although the exchange rate turned lower when the Turkish Banking Association was reported to be organising a coalition of locals to defend the currency.

"The lira has broken explosively out of its narrow sideways trading range, to which it stuck almost resembling a pegged currency since mid-June. Such a breakout indicates that whatever intervention mechanism had kept the exchange rate flat has failed," says Tatha Ghose, an analyst at Commerzbank. 

Above: USD/TRY rate shown at daily intervals alongside EUR/TRY (orange line, right axis).

"Various capital controls and restrictions, which Turkish policymakers were using, obviously no longer suffice to keep the lira stable, but as base-case, we should anticipate more of these. In the end, however, only a qualitative turnaround in CBT’s monetary policy regime can stabilise the exchange rate in the medium-term," Ghose says.

The Turkish Lira has depreciated against the Dollar by around 60% per year on average in the last decade, with the depths of depreciation often seen in summer markets dominated by low volumes, which are where relatively small transactions can have outsized impacts on prices. 

In 2018 the depreciation reached crisis proportions amid a geopolitical spat with the U.S. but during the ensuing Lira sell-off, the Euro-to-Dollar rate tanked in moves that many attributed to supposed market fears about the loan exposure that European banks might have to the Turkish economy. 

The Lira clawed back lost ground through Friday, keeping alive August's increasingly positive correlation between USD/TRY and EUR/TRY, but was slipping again into the European close. This was as earlier advocates of a continued Euro-to-Dollar rally cooled their enthusiasm fior the single currency and as long-term Lira bears sharpened their knives.

"The Turkish lira (TRY) has lost 6% over the last few days and nearly 25% since year-end. We have been Negative Turkish lira continuously over the past two years since USD/TRY 4.59," says Thanos Papasavvas, CFA chief investment officer at ABP Invest. "We remain Negative as the twin deficits, inflation, unorthodox macroprudential measures and lack of central bank independence raise key concerns. Last but not least, the country’s geopolitical isolation from Russia, EU and US seems to continue, with the latest developments in Libya not helping. During the Covid-19 crisis when emerging market currencies weakened and we took the opportunity of Upgrading our Negative outlook on the South African rand due to its more attractive valuations, we maintained our Negative outlook on the lira. And even today, whilst the TRY is making new all time lows we are still holding on to our Negative view."

Above: USD/TRY rate shown at weekly intervals alongside EUR/TRY (orange line, right axis).