* Current account deficit narrows in Q1
* Tight policy until improvement in inflation outlook
* Central bank credibility increases
By Seda Sezer and Sujata Rao
ISTANBUL/LONDON May 14 (Reuters) - Turkey's shrinking current account deficit, its improved policy credibility and an all-out hunt for yield are steadily pushing the lira, one of last year's emerging-market laggards, towards the key 2 per dollar level.
The lira appreciation is likely to be short-lived. Turkey still relies on external funding; political unrest could yet erupt during upcoming elections. But for the time being, global and domestic factors are working in its favour.
After losing a fifth of its value last year against the dollar, the lira is up 3.8 percent since the start of 2014 to around 2.07 per dollar. It has risen 15 percent from the record lows it reached in January, before the central bank stepped in to defend it with a 500-basis-point increase in interest rates.
It firmed to 2.0620 against the dollar on Wednesday, its strongest since Dec. 18, on expectations the European Central Bank will ease monetary policy. Just before the rate rise, it hit 2.39 per dollar, its record low.
"In the short term, there is very little to stand in the lira's way," UBS strategist Manik Narain says.
"There is a complete lack of volatility in U.S. Treasuries, which is generating a very powerful bid for carry and Turkey offers nearly 9 percent. (Lira at 2 per dollar) is possible given carry is the dominant investment theme in this market.".
He was referring to investors' hunt for higher yields via overseas investments - a fund manager who would earn 2.6 percent in 10-year U.S. Treasuries and 1.4 percent in German Bunds can pick up 9 percent on similar tenor Turkish bonds.
Turkey is benefiting not only from the emerging markets rebound but also from allocations out of sanction-hit Russia and from the euro zone periphery, where once-high yields have fallen to multi-year lows. All this brought flows worth $2.3 billion to Turkish stocks and bonds in April, central bank data show.
"The lower the yield goes on the periphery, the more attractive Turkey looks," said Steve O'Hanlon, head of emerging fixed income at ACPI Investments, who is overweight Turkey. "I think there is a bit more upside, as long as general conditions of emerging markets remain buoyant."
Turkish lira bonds have returned more than 10 percent on the GBI-Global index of local debt this year, almost topping the index after fellow high-yielders Brazil and Indonesia.
The lira is also getting support at home. Inflation is running at an annual rate of about 9 percent, ruling out interest rate cuts of any magnitude. The central bank expects inflation to begin falling in June but still sees it at an above-target 7.6 percent at the end of the year.
Second, Turkey's current account deficit, the biggest in emerging markets, shrank by 30 percent year-on-year in the first quarter of 2014 as higher interest rates curbed domestic demand. That makes the country a bit less vulnerable to the impact of global monetary tightening.
"If the rebalancing on the current account deficit - Turkey's key achilles heel - continues we are likely to see 2 lira to the dollar this year," Standard Bank analysts said.
Third, investors are happier with the central bank's return to the orthodoxy of higher interest rates. It had followed unconventional - and what many considered overly loose - monetary policies since end-2010.
The bank has also stood up to government pressure for a rate cut so far. Governor Erdem Basci and his colleagues have reiterated that policy would stay tight inflation outlook has clearly improved.
"The fact that Basci was willing to cross swords with the government in January by hiking rates aggressively and is still talking tough on inflation is reassuring to investors," said Nicholas Spiro, head of Spiro Sovereign Strategy.
But some caution is creeping in. Turkey faces elections in August. It funding gap equals 6 percent of annual economic output. And savings rates and labour productivity are low.
"While we wouldn't be surprised if the lira strengthened further against the dollar over the coming weeks, over a 12- to 18-month horizon, we think it's more likely than not that it will weaken," said William Jackson at Capital Economics.
Analysts polled by Reuters this month predict the lira will trade at 2.23 per dollar in a year's time
Also, the central bank may succumb to the pressure to cut rates. Basci and his colleagues have said they could consider lowering rates once inflation peaks.
It is "dangerous" for the central bank to be talking already of cutting rates, Narain of UBS said.
"There should be no discussion at all of easing at this point," he said. "It beggars belief that with inflation at 9 percent, they can entertain any thoughts of easing." (Editing by Larry King)