Even as markets recover from one of the most volatile months in years, the odds are in favour of a popular currency trade that has attractive yields and low volatility.
Investors are once again engaging in so-called carry trades in developing economies, where they borrow in lower-yielding currencies in order to purchase those that provide higher yields, as there are signs that the US economy is slowing down and that global interest rates are peaking. The International Monetary Fund has predicted that emerging markets, notably those in Asia, will be a bright light even as the US economy weakens, thus for the first time in years, it appears like the ideal conditions are in place for the approach to work.
After three years of losses, a Bloomberg measure of borrowing dollars and investing the money in a basket of emerging currencies has recovered nearly 5% this year, reaching its highest level since 2021. Returns this month skyrocketed above a developed-market peer index as speculation that the Federal Reserve is nearing the end of its tightening cycle increased because to fears of a banking crisis that has already started in the US.
Contrary to expectations, March’s spike in financial market volatility might be just what’s needed to get EM carry trades back on track “Eimear Daly, a strategist for emerging markets at NatWest Markets Plc in London, said this. “Investors will be enticed back into EM high-carry currencies, with big carry on offer, now that US carry is probably capped.”
Although fast policy tightening by major central banks appears to be coming to an end amid concerns over growth, interest in carry trades has been reviving. Notwithstanding the volatility of the foreign currency markets, which has the potential to drastically alter possible returns, that has been sufficient to increase trust in the strategy.
Carry strategies are starting to appear more appealing once again, and emerging-market foreign exchange returns fare better in US-centric recessions “Adam Pickett and other analysts at Citigroup Inc. penned a note on Thursday. “EMFX might be a better area to hide out because emerging-market fixed income and equities may continue struggle.”
According to data provided by Bloomberg, dollar-funded trades with money invested in the currencies of Mexico, Colombia, and Hungary have all returned over 6% this year. According to data as of Friday, 17 out of 23 tracked emerging-market currencies have shown a profit this year while the majority lost money in 2018.
Early Arrivals
Since their central banks increased interest rates to combat inflation ahead of their developed counterparts, the central banks of a number of emerging-market currencies are particularly alluring carry targets.
“Most EM countries have increased interest rates significantly, many beginning before the Fed and raising rates even further, therefore many EM yields are appealing, “said Rajeev De Mello, a portfolio manager for global macro at Geneva-based GAMA Asset Management SA. He said that the currencies of Brazil, Mexico, India, the Czech Republic, and Poland make for appealing carry trading targets.
The rate hikes by Brazil’s central bank began as early as March 2021, and they totaled 1,175 basis points to reach the current rate of 13.75 percent. With a premium of 875 basis points above the Fed’s benchmark rate, the country’s Selic rate provides a significant buffer to counteract any potential actual deterioration.
Based on US overnight indexed swaps, benchmark rates in Brazil, Mexico, Colombia, and Chile are all at 7% or higher, easily exceeding current forecasts for the Fed rates to peak at close to 5%.
Reduce volatility
Currency market swings, which soared up last month amid worries of a financial crisis, are starting to decline once more and pose less of a threat to potential carry traders.
At the middle of March, when banking tensions were rising, a JPMorgan Chase & Co. index of one-month implied volatility in emerging-market currencies reached a high of 11.1%. This month, it dropped to 9.9%. The Group of Seven’s equivalent measure of volatility decreased from 11.7% to 10.1%.
The EM index was twice as high as its peer at the end of 2021, reflecting the currency volatility brought on by developed-market central banks last year. Today, the two measures are practically at the same level.
Various Growth
If the prospect for economic development is any indication, emerging markets are likely to keep their interest rate advantage over the US.
The International Monetary Fund predicted in January that American GDP will fall to 1.4% this year and then 1% in 2024. In contrast, according to data from the IMF, growth in developing markets will pick up to 4% in 2023 and then 4.2% the following year.
In light of indications that the global economy is faltering, the IMF is anticipated to release its most recent forecasts this week.
The mild US recession and range-bound dollar in our central scenario should underpin the EM carry trade, “said John Harrison, managing director at TS Lombard in London for emerging-market macro strategy. According to him, the Brazilian real and Mexican peso appear to be the top EM carry trade targets since they will be supported by active central banks and relatively high real interest rates.
What to See
On Tuesday, the Bank of Korea will publish its key rate, with experts predicting that policymakers would maintain their reference rate at 3.5% for the second meeting.
During the course of the week, investors will be watching for indications that the rate of price growth is slowing further as inflation data are due from India, China, Hungary, and Poland.
The central bank of Peru meets on Thursday to decide on interest rates after maintaining borrowing costs at 7.75% at its last two meetings.
