The Central Bank of Turkey takes action to counter short-term arbitrage transactions, curbing the inflow of "hot money" into the lira market.

Turkish policymakers are taking actions to curb the influx of so-called "hot money" into the lira market, launching a counterattack against one of the most profitable currency arbitrage trades globally. Despite the central bank's strict control over the lira market and allowing the currency to gradually depreciate, traders say that market volatility has become more unpredictable in recent times. Bloomberg calculations show that especially in the past few Fridays, the lira's depreciation speed has been three to four times faster than the average on other trading days. This acceleration of depreciation on Fridays directly hits a popular short-term trading strategyinvestors buying lira through overnight swaps on Thursday evening to earn weekend interest and then closing their positions on Monday. The sharp drop in the lira on Fridays makes these weekend arbitrage trades unprofitable. With the Turkish central bank's interest rates close to 50%, the country has once again become a hot destination for arbitrage tradersinvestors borrow funds from low-interest rate countries to invest in assets of high-interest rate countries. Insiders reveal that Turkish officials are trying to prevent the shortest-term arbitrage trades, fearing that a rapid withdrawal of such funds could trigger a surge in market volatility. A similar crisis occurred in March this year: after Istanbul mayor and President Erdogan's strongest political opponent, Ekrem Imamoglu, was unexpectedly arrested, the lira plummeted by 10% in a matter of hours. Finance Minister Simsek stated then that the sell-off was mainly triggered by foreign investors withdrawing their lira positions. "The authorities are not particularly keen on attracting short-term arbitrage funds," pointed out Elgin Isik, Chief Economist at Istanbul QNB Bank, "they have witnessed sharp fluctuations in exchange rates and foreign exchange reserves when such trades swiftly exit." The central bank declined to comment on this. The March sell-off was eventually contained through a hike in interest rates, the introduction of new measures to reduce lira liquidity, and an increase in the reserve requirement ratio for banks' short-term overseas liabilities. Additionally, the overall attractiveness of emerging market assets was bolstered after US President Trump temporarily suspended some aggressive tariff policies. Although the lira continues to depreciate against the dollar, the Turkish government is pushing for a policy of "real appreciation," where the currency depreciates less than consumer inflation. With expectations of monthly inflation slowing down, policymakers are finding it increasingly difficult to predict the pace of real appreciation. However, arbitrage trades still remain profitable. Based on measures from rolling one-month forward contracts, Bloomberg shows that the return on lira arbitrage trades for May is at its highest since 2021, enough to offset losses from March. Independent Turkish economist Haluk Burumcek estimates that approximately $3.4 billion has flowed into arbitrage trades from April 18 to last week. Traders reveal that this trade has been profitable for five consecutive quarters, with the last time such a long winning streak recorded back in 2012, mainly being driven by inflows of short-term capital (i.e., hot money) and ultra-short-term positionsheld for typically less than a week. Morgan Stanley, Deutsche Bank, and ING recently reiterated their bullish recommendations for lira arbitrage trades, while HSBC advocates buying long-term local currency bonds.