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The Turkish lira and benchmark sovereign bond hit a record low as the threat of U.S. sanctions added pressure to already ailing markets.
The U.S. dollar rose to 5.4 against the lira on Monday before trading around 5.29 on Tuesday. Turkey's 10-year bond fell to a record low on Tuesday, pushing its yield up to around 20 percent before hovering around 18.8 percent. Bond prices move inversely to yields. Turkish capital markets have struggled this year as the country deals with a weakening economy.
The sharp moves down come after President Donald Trump threatened last month to slap "large sanctions" on the Middle Eastern nation if it refuses to free Andrew Brunson, an evangelical pastor. The U.S. then announced on Aug. 1 sanctions on Turkey's justice and interior ministers, prohibiting U.S. citizens from doing business with them.
"This is a shot across the bow," said Marcus Chenevix, an analyst at TS Lombard. "Now, I think the U.S. will give them time to respond. It's not like the U.S. sees this as a pressing political matter, it just can't seem to be backing down to these hostage tactics."
Turkey detained Brunson in October 2016, accusing him of spying and trying to overthrow the government after a failed coup earlier that year. Trump demanded in a July 26 tweet the Turkish government release Brunson.
A Turkish delegation is headed to Washington to discuss the conflict between the two countries, according to multiple reports.
TS Lombard's Chenevix said that an ideal response to the U.S. sanctions threat would be for the Turkish to release Brunson, as the situation adds even more uncertainty to its already weakened capital markets.
For the year, the lira is down nearly 40 percent against the U.S. dollar. Turkish stocks have also taken a beating in 2018. The iShares MSCI Turkey exchange-traded fund (TUR) is down 39 percent year to date. Turkey's stocks also missed out on the broad rally in emerging markets last month, falling 6.7 percent in July while the iShares MSCI Emerging Markets ETF (EEM) rose 3.5 percent.
"There's an underlying trend and a short-term trigger here," said Chenevix. "The short-term trigger is the threat of sanctions. The underlying trend is the Turkish economy is in an overheating crisis."
"Given the high, volatile inflation of the overheating crisis, Turkish monetary-policy makers are always playing catch-up," he added. "The Turkish economy is headed for a hard landing. They're going to face a steep correction and a big drop in growth."