The Turkish lira’s crash was one of the most noticeable events in the currency market over the last month, coming as a result of the escalating conflict between Turkey and the U.S. Due to the strong interconnection between Turkish and European economies, Turkey’s monetary crisis, in its turn, induced a significant weakening of the euro against the U.S. dollar in the mid-August of 2018. 

The Turkish-American conflict was triggered, first and foremost, by the imprisonment of American pastor Andrew Brunson, which has gone on since 2016. He had been accused of being involved in the 2016 attempted coup d’état. After several failed attempts by U.S. officials to have the U.S. citizen released from jail, in August, Donald Trump’s Administration decided to take on sanctions against Turkey. On August 1st, the U.S. Department of the Treasury imposed personal sanctions against two high-ranking Turkish officials: Abdulhamit Gül, the Minister of Justice, and Süleyman Soylu, the Minister of the Interior. Furthermore, on August 10th, Donald Trump announced the doubling of steel and aluminum import tariffs for Turkey, thus putting more pressure on the Turkish lira. Later, on August 16th, Steven Mnuchin, the U.S. Secretary of the Treasury, declared that the US might impose new sanctions against Turkey if the country does not release American pastor Andrew Brunson. 

The influence of the events in Turkey on the European currency’s exchange rate may be explained, in its turn, by investors’ concern that the Turkish monetary crisis might spread into the key member states of the Eurozone. It should be mentioned that European countries are not only Turkey’s key trade partner, but also one of its main creditors. Thus, if the Turkish monetary crisis turns into a full-fledged economic crisis, Europe’s banking system may be faced with the need to significantly re-evaluate, or even to write off the Turkish debt. Considering the weaknesses of banking systems in a number of European countries, this might result in grave liquidity problems for the EU, which was the reason of the euro’s strong downward trend, reaching 1.14 in the mid-August. 

At the same time, in the second half of August, the euro exchange rate quickly recovered losses and returned to the range of 1.16 – 1.17, following Donald Trump’s public criticism of Jerome Powell, the Chairman of the Fed, and his policy of raising the base rate. The euro is also helped by the U.S. significant inflation slowdown reported at the end of August 2018. In August, the U.S. base consumer price index grew by just 2.2% YoY, which is not only 0.2% less than the expectations of analysts, but is also lower than the July figure, as the U.S. Department of Labor reported. If the slowing trend of inflation continues in the U.S., the Fed may face questions regarding this year’s two increases of the base rate, which, in its turn, may put pressure on the U.S. dollar exchange rate. 

The upcoming midterm congressional elections in the U.S. are an additional source of pressure on the dollar, as their results are uncertain, and may not only entail changes to the representative body, but also to the U.S. domestic/international policies. Currently, the Republican Party is in control of both Chambers of the U.S. Congress. However, according to a number of experts, the November elections may result in the Republicans losing their majority in the House of Representatives. This, in turn, will impede Donald Trump’s ability to pass his initiatives through Congress. It should be mentioned that as of today the Republican Party is not likely to lose both of the Chambers of the Congress (which would enable the Democrats to initiate the impeachment procedure). However, at this point such a scenario cannot be excluded from consideration entirely. 

At the same time, the ongoing Fed’s balance sheet shrinkage and the related dollar liquidity withdrawal from the market (to which we made numerous references in our previous economic reviews) remain the key factor supporting the U.S. dollar. Since the beginning of the shrinkage, over the period from October 2017 to September 11th, 2018, the Fed has withdrawn about $250 billion US from the system. As the volume of shrinkage increases quarterly (starting from October, the Fed is going to raise the monthly volume of shrinkage to $50 billion US), by the end of the year the Fed is likely to have reduced the volume of dollar liquidity in the market by another $180 – 190 billion US. In its turn, the ECB proceeds with the quantitative easing, with monthly asset purchases of EUR30 billion, which will only be reduced to EUR15 billion in October.

As long as such a divergence is present in the policies of the two main central banks, the euro exchange rate will experience double pressure (strengthening of the dollar due to the balance sheet shrinkage and the growing base rate; weakening of the euro due to the ECB’s ongoing issuance).