UPDATE 2-Turkey's markets rebound after politics-driven tumble

Turkey's financial markets rebounded on Friday having been ​rattled this week by political manoeuvres against the country's main opposition party and ‌growing ​pressure on the lira.

The benchmark BIST 100 index rose 4.5% in Istanbul, recovering from a 6% plunge on Thursday that had triggered a suspension of trading after a top court moved to effectively oust main opposition leader Ozgur Ozel. Bank stocks were up nearly 3% after a near 9% drop in the previous ‌session that had been their biggest slump in over a year.

There was an equally swift rebound in the country's bonds, too. They had suffered their steepest selloff since March during Thursday's turbulence, but had already made most of it back thanks to gains of up to 1.5 cents in international markets. There were still signs of strain though as traders wondered whether the latest move against the opposition party might be a prelude to early ‌elections in Turkey given it could boost President Tayyip Erdogan's chances of securing another term.

The Turkish lira, which has been on a managed slide and is down nearly 6% this year, slipped to ‌its latest record low of 45.74 per dollar. The cost of insuring Turkish debt against default via CDS climbed to a six-week high after a sharp rise. The opposition Republican People's Party (CHP) condemned Thursday's ruling as a "judicial coup" but Turkey's Vice President Cevdet Yilmaz shrugged it off as "daily market developments" and said Turkey would remain focused on bringing down inflation which topped 32% last month. POLITICAL RISKS BUILD

Piotr Matys, a senior FX analyst at InTouch Capital Markets, said the ruling added to the long list of moves against Erdogan's political opponents ⁠over the ​last decade, including the imprisonment of former Istanbul mayor Ekrem ⁠Imamoglu. "A leopard can't change its spots," Matys said as he and other analysts said the central bank may now be forced to raise interest rates, given the uncertainty that adds to existing pressure on the currency and a renewed uptick in inflation. JPMorgan's strategists ⁠said they expect rates to be hiked to 40% from the current 37%, possibly even before the central bank's next planned meeting on June 11.

"Rising political risks come at an unhelpful time for the lira," they said, adding that there ​was also a risk that the country's currency reserves could turn negative if investors sense another crisis could be brewing. They estimate the lira "carry trade position" at $29 billion.

Foreign investors hold $15 billion, or 6.4%, ⁠of Turkey's lira-denominated government bonds, as well as a hefty $86 billion of its largely dollar-denominated "external debt" and $46 billion, or 35%, of the country's total equity stock. "Should significant capital outflows occur, the CBRT's net FX reserves are expected to reach negative levels this year," JPMorgan's analysts said.

RATE ⁠HIKE ​EXPECTATIONS GROW The central bank published its latest financial stability report on Friday, saying pressures on Turkey's markets stemming from the Iran war were being managed with proactive monetary policy as well as liquidity and reserve management tools. Foreign exchange reserves have fallen $50 billion from their peak. As of May 20, it is estimated to have 'gross' FX reserves, including gold, totalling $166 billion. 'Net' FX reserves excluding gold, however, stand at a more modest $35 billion. "If ⁠the CBRT continues to burn through its reserves at a rapid pace, it may have to seriously consider raising interest rates", Matys said. "In fact, an emergency rate hike cannot be excluded".

Turkish bonds have underperformed ⁠broader emerging market bond indexes this year and domestic 10-year ⁠yields, a proxy for government borrowing costs, are now at a record high of over 33% . Ata Invest's head of research Cemal Demirtas said investors were likely forced into margin calls triggered by Thursday's selloff, although Friday's stabilisation was encouraging.

"In our view, the selloff was exaggerated by panic," he explained, saying the court's decision ‌to announce its move against the ‌opposition while markets were open had been like "performing surgery without anaesthesia". (Additional reporting by Mirac Eren Dereli and ​Karin Strohecker; Editing by Louise Heavens and Chiara Rodriquez)

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