A short-lived respite for dollar-funded emerging market carry trades appears to be over, with a rebound in US inflation making the outlook increasingly treacherous.
A Bloomberg index of these bets has fallen more than 4% in the past two months, the biggest drop since March 2020 for a strategy of borrowing in dollars and investing in developing country currencies. The fastest US inflation in three decades is putting pressure on the Federal Reserve to adjust, raising the prospect of higher costs for dollar borrowers and less additional yield, or carry.
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It’s a quick change of mind for traders, who just two months ago took comfort in the Fed’s dovish message about the gradual pace of tightening, and were seizing the opportunity to rack up carry trades. Many of these bets are now being undone due to growing concerns about inflation and whether central banks will have to catch up on aggressive hikes.
“Much higher-than-expected inflation readings in the US and China will wreak havoc on the narrative that inflationary pressures are transitory,” said Mitul Kotecha, chief emerging markets strategist for Asia and Europe at TD Securities in Singapore. . “This bodes ill for EM carry trades in the short term as it narrows the relative performance gap.”
A tightening of global liquidity conditions as the Fed reduced its asset purchases may also pose some hurdles for emerging market carry, Kotecha said.
Traders could turn to the euro and the yen to reduce financing costs. Both currencies are among the worst performers in the Group of 10 space so far this quarter, and the Bank of Japan and the European Central Bank are expected to remain accommodative.
Losses in the Bloomberg index of emerging market carry trades since late August come after it rallied 1.5% that month. The indicator, which covers eight currencies, including the Brazilian real, the Mexican peso and the Indian rupee, is heading for a second annual loss.
Among the worst results in the past two months, an exchange of loans in dollars and purchases of Turkish liras has lost 11%, while investments in the South African rand or the Hungarian forint have fallen more than 6%. On the positive side, the placement of funds in the Argentine peso has returned 7%.
There is at least some prospect that emerging market central banks will raise interest rates quickly enough to guarantee a sufficient yield premium to improve carry yields. Investors can get more guidance on this this week with the political decisions of Turkey, Indonesia, the Philippines and Hungary.
The outlook for carry looks better for currencies in the Americas and the Europe, Middle East and Africa region than it does for Asia, according to Bloomberg Intelligence.
The lira, Russian ruble, Mexican peso and rand are likely to deliver the best yields, while the rupee and rupee are the least attractive, chief emerging markets credit strategist Damian Sassower wrote in New York. research note this month.
“Interest rates are rising faster in Latin America and EMEA,” he said. “Asian currencies have lost their luster in 2021 as short-term carry embedded in high-yield economies continues to decline.”
These are some of the main events and data to watch out for this week:
- The central banks of Turkey, Indonesia, the Philippines and Hungary will review the policy configuration.
- Indonesia and the Philippines will likely keep rates on hold as officials focus on supporting growth recovery, according to Bloomberg Economics.
- Turkey’s decision will be in the limelight after two surprise rate cuts in a row since September that pushed the lira’s depreciation against the dollar so far this year to more than 20%.
- Hungary’s central bank is under pressure to increase the size of monthly rate hikes as inflation rises. The magnitude of the rate hikes fell to 15 basis points in September and October after steps of 30 basis points in each of the previous three months.
- The gross domestic product data comes from countries such as Russia, Thailand, Colombia, and Chile.
© 2021 Bloomberg