(Bloomberg) -- Turkish assets rallied as one of the country’s courts ruled to release the jailed U.S. pastor Andrew Brunson to house arrest, fueling speculation the move will ease heightened tensions between the NATO allies.

The lira gained as much as 1.4 percent, government bonds surged and the benchmark stock index jumped more than 3 percent. Brunson’s almost two-year long detention is among a list of contentious issues seen as a potential trigger for U.S. penalties on Turkey and has weighed on sentiment. Wednesday’s gains brought some relief to markets that came under fire after the central bank left interest rates unchanged on Tuesday.

Turkish assets have suffered some of the steepest losses among emerging markets this year as investors worry that the country’s policy makers are putting price stability at risk by heeding to President Recep Tayyip Erdogan’s demands to refrain from raising borrowing costs. With U.S. lawmakers in Congress and the Senate publicly urging stronger actions against Turkey, including sanctions, traders are bracing for a potential escalation if Brunson isn’t released.

Brunson’s house arrest is providing “a bit of much needed positive news flow around Turkey,” said Timothy Ash, a strategist at BlueBay Asset Management. “I guess the market is reading this as leading the way for some kind of deal between the U.S. and Turkey, which would include Brunson’s eventual release.”

The Turkish currency was 1.1 percent stronger at 4.8298 per dollar as of 6:28 p.m. in Istanbul. The yield on 10-year government debt fell as much as 136 basis points to 17.31 percent and was set for its biggest drop on record, following a 184 basis-point jump on Tuesday, also unprecedented. The Borsa Istanbul 100 stock index advanced 3.5 percent, spurred in part by a rally in Turkiye Halk Bankasi AS.

A senior executive at the state-run lender was convicted in New York in May for evading a U.S. embargo on Iran. The shares jumped as much as 16 percent in Istanbul on speculation a thaw in relations with the U.S. could help protect the bank from any fines.

Still, analysts including those at Rabobank and Capital Economics said the nation’s assets are vulnerable to further pressure, potentially forcing the central bank into raising rates in an emergency meeting to fight double-digit inflation.

The lira could fall to a fresh record low in the coming weeks and the authority may not be able to wait until its next scheduled meeting on Sept. 13 to “rectify its monetary-policy mistake,” said Jan Lambregts, a strategist at Rabobank in London. “The bias was firmly skewed in favor of a hike.”

To contact the reporter on this story: Constantine Courcoulas in Istanbul at ccourcoulas1@bloomberg.net

To contact the editors responsible for this story: Ven Ram at vram1@bloomberg.net, Scott Hamilton, Anil Varma

©2018 Bloomberg L.P.

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