By Libby George and Karin Strohecker
LONDON (Reuters) -Turkey's sovereign dollar bonds and equities tumbled, and the cost of insuring exposure to the country's debt spiked as Turkey's presidential race heads to a runoff with incumbent Tayyip Erdogan leading his opposition rival.
Turkey's main banking index slumped by more than 9% as markets gauged potential fallout from a possible continuation of Erdogan's unorthodox fiscal policies.
The Istanbul bourse was trading more than 4% lower, after an earlier 6.38% drop triggered a market-wide circuit breaker.
The lira stood at 19.66 to the dollar at 1348 GMT, after reaching 19.70 in earlier trading, its weakest since a record low of 19.80 hit in March this year following deadly earthquakes. It was on track for its worst trading session since early November.
Turkey's election board confirmed a May 28 runoff between Erdogan and opposition rival Kemal Kilicdaroglu after neither candidate secured the 50% threshold to win in Sunday's election. With 99% of ballot boxes counted, Erdogan led with 49.4% of the vote over Kilicdaroglu's 44.96% share.
In the parliamentary vote, the People's Alliance including Erdogan's AKP appeared headed for a majority.
"From the market reaction so far it's very conclusive that the market is expecting Erdogan to win in the second round and we will get more of the same," said Dan Wood, portfolio manager of emerging market debt at William Blair.
"You can see on the sovereign bonds, investors really voted with their feet."
Dollar-denominated sovereign bonds issued by Turkey fell by more than 7 cents, while the five-year Turkey credit default swap spread jumped 114 basis points (bps) to 606 bps, according to S&P Global Market Intelligence, the highest since November 2022. By 1412 GMT, it stood at 599 bps.
The presidential vote will decide not only who leads Turkey and shapes the foreign policy of the NATO-member country of 85 million people, but also how it is governed and how it tackles a deep cost-of-living crisis.
Last week, Turkish stocks and bonds rallied when third-party presidential candidate Muharrem Ince withdrew from the race, boosting expectations of a Kilicdaroglu win.
"Now we are back to square one," said Emre Akcakmak, senior consultant with East Capital.
"I think if Erdogan is continuing, which is the strong base case, then foreign investors will be on the sidelines," Akcakmak added.
Richard Briggs, Candriam senior fund manager for emerging market debt, said that an Erdogan win could mean a continuation of economic imbalance, unorthodox monetary policy and costly efforts to prop up the lira.
"If Turkey continues to run large current account deficits, once those flows halt or reverse, pressure on the currency and the economy could be severe without a credible policy framework which is less likely under the existing administration," Briggs said.
JPMorgan had forecast that the lira could reach 24-25 to the dollar and Goldman Sachs calculations showed the market was pricing the lira to weaken by 50% in the next twelve months.
On Monday, lira volatility gauges fell, suggesting the currency could remain stable.
The lira has weakened 5% since the start of the year, and has lost almost 95% of its value over the last decade and a half as sugar-rush economic policies sparked spectacular boom and bust cycles, rampant inflation and currency market turmoil.
(Reporting by Karin Strohecker and Libby George in London and Amruta Khandekar in Bangalore; Editing by Sonali Paul, Christopher Cushing and Emelia Sithole-Matarise)
