EM Strategy Desknote Turkey: TRY running out of options We close 1y1y TRY ccy rates payer at 13.60% for a profit of +40bp. Now, we shift our focus to TRY FX where we highlight the possibility of accelerated depreciation.TRY FX forwards are based on the 12%+ premium currently embedded in the cross- currency (ccy) curve. The TRY basket (50% USD / 50% EUR) is depreciating faster than the path predicted by these forwards, from 1-week up to 12-months.This suggests the current level of rates is not high enough to offset demand for hard currency. TRY ccy rates have reacted to the poor performance of TRY FX by pricing out cuts beyond 1y and pricing in more hikes into 9m.For now, this process is helping to slow the depreciation of the TRY spot but, with no hikes priced up to 3m, we think the steepness of the ccy curve is unlikely to continue. We therefore expect uncertainty over whether forward rates will increase, and this increased volatility in forwards will likely accelerate TRY spot depreciation.Strategy: Buy USDTRY 3-month 25 delta call option for 1.05% of notional (spot: 3.85)Return synchronisation Realised forward returns in the TRY basket (50% USD / 50% EUR) have turned negative across time horizons, ie spot is currently underperforming forward projections on a one-week, 1- month, 3-month and 6-month basis (Chart 1, overleaf). This means that, on average for the last six months, investors who have been long the TRY versus the USD and EUR have not been rewarded for funding Turkeys current account deficit, despite rate hikes by the Turkish central bank (CBRT). Previously, such a broad synchronised underperformance has been followed by a burst of dependence in returns and acceleration in the FX sell-off, as shown by the period indicated in yellow in Chart 1. For details on how this process works, see Turkey: Breaking bad, Turkey: Burst of dependence (p. 15-16), and Turkey: Breaking the dependence. In short, beyond a critical threshold of losses, negative returns start to be more correlated as more and more market participants are forced to cut their positions, leading to a cascade of stop-losses being triggered and more selling. The seed for such a drawdown has previously been when 1-week returns have turned negative by more than one standard deviation, and longer-term returns have also been negative. Current returns are showing this exact pattern. We therefore think there is a risk that TRY depreciation will accelerate, unless the CBRT takes steps to slow the process, which we think is unlikely. The CBRTs knock-in strategy In our latest publication, Turkey: Back to the (undiscounted) future, we recommended paying 1y1y TRY ccy rates, focusing on the CBRTs reaction function. The central bank has historically pursued monetary tightening only after the currency has already lost significant ground and expectations of future depreciation have risen, rather than acting pre-emptively to over-tighten and bring inflation down substantially. This can be described as a knock-in strategy. The market has consistently priced in rate hikes between 6m and 1y. Beyond 1y, the market has consistently priced rate cuts (Chart 2). However, these expectations have previously been disappointed when the CBRT has decided to postpone monetary tightening, which has kept inflation on an upward trajectory and meant that rate cuts never materialise. This document has been produced by: Piotr Chwiejczak BNP Paribas London Branch FX it does not purport to be an exhaustive analysis, and may be subject to conflicts of interest resulting from their interaction with sales and trading which could affect the objectivity of this report. This document is non- independent research for the purpose of the UK Financial Conduct Authority rules. For the purposes of the recast Markets in Financial Instruments Directive (2014/65/EU) (MiFID II), non-independent research constitutes a marketing communication. This document is not investment research for the purposes of MiFID II. It has not been prepared in accordance with legal requirements designed to provide the independence of investment research, and is not subject to any prohibition on dealing ahead of the dissemination of investment research. The content in this document/communication may also contain “Research” as defined under the MiFID II unbundling rules. If the document/communication contains Research, it is intended for those firms who are either in scope of the MiFID II unbundling rules and have signed up to one of the BNP Paribas Global Markets Research packages, or firms that are out of scope of the MiFID II unbundling rules and therefore not required to pay for Research under MiFID II. Please note that it is your firms responsibility to ensure that you do not view or use the Research content in this document if your firm has not signed up to one of the BNP Paribas Global Markets Research packages, except where your firm is out of scope of t