The US dollar surged again on Wednesday against a basket of emerging market (EM) currencies, adding urgency to the question of which EM countries are most vulnerable to a receding “carry trade”, the multitrillion dollar flow that has swollen domestic debt markets since 2009.
A soaring dollar piles pressure onto EM carry trade investors, who typically borrow dollars at low interest rates in order to buy high yielding EM domestic debt. When the dollar surges, they suffer currency losses that offset their interest rate gains, prompting them to sell.
Just how risky is picking up pennies in front of a steamroller?
The metaphor is used to describe investment strategies that consistently earn a small return but which are vulnerable to dramatic losses, such as the in-vogue carry trade.
It consists of borrowing cheaply in a hard currency such as the dollar and investing in a higher-yielding one, typically through government bonds or forward currency contracts. The objective is to capture the positive differential in interest rates – the “carry” – and it has become a defining feature of investing in emerging markets this year.
However, for some market watchers there are signs that the trade is being stretched – and investors risk being wrong-footed.
A few months ago, fixed income investors couldn’t get out of Brazil, South Africa and Turkey quickly enough.
The rump trio of the so-called ‘fragile five’ emerging market economies were at the eye of a storm that roiled financial markets in January and pummelled their currencies as weaknesses in their economies were exposed.
Things have changed.
The hawkish surprise from the US Federal Reserve on Wednesday has dramatically undermined the carry trade for high interest countries. James Mackintosh, investment editor, looks at how this will hurt both developed and emerging markets.
Remember the yen carry trade? Sure you do: when lots of smart people took advantage of Japan’s low interest rate to borrow and then invest in currencies with higher interest rates? (Ah, that carry trade.)
Well, with Japan’s new aggressive monetary stance, it’s back (in a way). And that should force EM currencies to appreciate, as before, shouldn’t it?
Perhaps not, according to Bhanu Banweja of UBS.
Mrs Watanabe is back. The fabled Japanese housewife investor, burned by her love affair with the Brazilian real, appeared to have rediscovered a taste for the carry trade.
The object of her affection this time? The Turkish lira.
The appetite for Turkish and lira-linked assets from yield-hungry Japanese retail investors has grown by leaps and bounds since the start of the year. From just $136m in 2010, lira-denominated Uridashi bond issuance – as foreign-currency debt sold to Japanese retail investors is called – reached nearly $2bn in the first six months of this year.