The stars are aligning in favor of a popular forex trade that benefits from attractive returns and low volatility, even as markets emerge from one of the most turbulent months in years.
Signs that the US economy is slowing and global interest rates are peaking are setting the stage for investors to revive so-called carry trades in emerging markets: borrowing in lower-priced currencies. yield to buy those that offer higher yields.
With the International Monetary Fund predicting that developing economies, particularly in Asia, will be a bright spot even as the US slows, the right ingredients for the strategy to succeed finally appear to be in place for the first time in years.
A Bloomberg gauge of borrowing dollars and putting the funds into a basket of emerging currencies has returned almost 5% this year, rebounding from three years of losses and hitting the highest level since 2021 as fears of a banking crisis, which started in the US, boosted bets that the Federal Reserve is near the end of its tightening cycle.
"Counterintuitively, the March episode of financial market volatility could be the ticket to revive emerging market carry trades," said Eimear Daly, emerging markets strategist at NatWest Markets Plc in London. "Now that the US carry is likely to be constrained, investors will be tempted to return to high-carry emerging market currencies, with significant carry-on bidding," he added.
Interest in carry trades has picked up as rapid policy tightening by major central banks appears all but over amid growth concerns. That has been enough to build confidence in the strategy despite the presence of volatility in the currency markets that can alter potential returns.
“Emerging market foreign currency yields hold up well in US-centric recessions, and carry strategies are starting to look interesting again,” Citigroup Inc. strategists, including Adam Pickett, wrote in a note. note Thursday. "Fixed income and EM equities could still struggle and Emfx might be a better place to hide."
Trades financed in dollars with money put into the currencies of Hungary, Colombia and Mexico have returned more than 6% this year, data compiled by Bloomberg show. Seventeen of the 23 emerging market currencies tracked have returned positively so far in 2023, while most have lost money last year, according to data through Thursday.
first movers
Several emerging market currencies are particularly attractive carry targets as their central banks raised interest rates to combat inflation ahead of their developed peers.
“Most EM countries have raised rates significantly, many started before the Fed and raised more, so a lot of EM yields are attractive,” said Rajeev De Mello, global macro portfolio manager at Gama Asset . Management SA in Geneva. Attractive target currencies for carry trades include those of Brazil, Mexico, India, the Czech Republic and Poland, he said.
Brazil's central bank started raising rates as early as March 2021 and continued to raise a combined 1,175 basis points to the current level of 13.75%. The national Selic rate offers an 875 basis point premium over the Fed's benchmark index, a sizeable cushion to offset any potential weakness in the Brazilian real.
Benchmark rates in Brazil, Mexico, Colombia and Chile are all at 7% or higher, well above current expectations that Fed rates will peak near 5%, based on overnight index swaps. USA
alleviating volatility
While fluctuations in the currency markets spiked last month amid fears of a banking crisis, it is starting to slow again, becoming less of a threat to would-be carry traders.
A JPMorgan Chase & Co. index of one-month implied volatility in emerging market currencies fell to 9.9% this month, from a high of 11.1% in mid-March when banking tensions were rising. A corresponding gauge of volatility in the G7 currencies decreased to 10.1% from 11.7%.
The level of the two indicators is now about equal after the emerging markets index was twice its peer at the end of 2021, a reflection of currency volatility caused last year by developed market central banks.
divergent growth
Emerging markets are poised to maintain their interest rate advantage over the US if economic growth prospects hold up.
US growth will slow to 1.4% this year and then to 1% in 2024, according to International Monetary Fund projections released in January. By comparison, growth in emerging markets as a whole will accelerate to 4% in 2023 and then to 4.2% next year, IMF figures show.
The IMF is expected to release its latest forecasts this week amid signs that the global economy is slowing.
“Our baseline scenario is a mild recession in the US and a range-bound dollar, which should support the EM carry trade,” said Jon Harrison, managing director of EM macro strategy at TS Lombard in London. The main targets for emerging market carry trades appear to be the Brazilian real and the Mexican peso, as these will be supported by proactive central banks and relatively high real interest rates, he said.
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