Popular emerging market FX trade back with global rates peaking

THE stars are aligning in favour of a popular currency trade that benefits from attractive yields and low volatility – even as markets come off one of the most turbulent months in years.

Signs that the US economy is slowing down and global interest rates are peaking are setting the stage for investors to revive so-called carry trades in emerging markets (EMs) – borrowing in lower-yielding currencies to buy those that offer higher yields. With the International Monetary Fund (IMF) 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 look finally in place for the first time in years.

A Bloomberg gauge of borrowing US dollars and putting the funds into a basket of emerging currencies has returned almost 5 per cent this year, bouncing back from three years of losses and hitting the highest since 2021. Returns leaped ahead of a developed-market peer index last month as fears of a banking crisis – begun in the US – bolstered bets the Federal Reserve is close to the end of its tightening cycle.

“Counter-intuitively, March’s bout of financial market volatility could be just the ticket for reigniting EM carry trades,” said Eimear Daly, an emerging-market strategist at NatWest Markets in London. “Now that US carry is likely capped, investors will be tempted back in to EM high-carry currencies, with significant carry on offer.”

Interest in carry trades has been rebounding as the rapid policy tightening by major central banks looks to be almost over amid concerns over growth. That’s been enough to build confidence in the strategy despite the presence of volatility in foreign-exchange markets that can upend potential returns.

“EM foreign-exchange returns hold up well in US-centric recessions, and carry strategies are starting to look interesting again,” wrote Citigroup strategists including Adam Pickett in a note last Thursday (Apr 6). “EM fixed income and equities might still struggle and EMFX may be a better place to hide out.”

Dollar-funded trades with money put into the currencies of Hungary, Colombia and Mexico have all returned more than 6 per cent this year, data compiled by Bloomberg show. Seventeen of 23 tracked EM currencies generated a positive return so far in 2023, while the majority lost money last year, according to data through Thursday.

A number of EM currencies are particularly attractive carry targets as their central banks raised interest rates to fight inflation in advance of their developed peers.

“Most EM countries have hiked rates significantly, many starting before the Fed and hiking by more, so many EM yields are attractive,” said Rajeev De Mello, a global macro portfolio manager at GAMA Asset Management in Geneva. Attractive target currencies for carry trades include those of Brazil, Mexico, India, the Czech Republic and Poland, he said. 

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Brazil’s central bank started raising rates as long ago as March 2021, and went on to hike by a combined 1,175 basis points to the current level of 13.75 per cent. The nation’s Selic rate offers a premium of 875 basis points over the Fed’s benchmark, a sizable cushion to offset any potential weakness in the Brazilian real.

Benchmark rates in Brazil, Mexico, Colombia and Chile are all at 7 per cent or higher, comfortably above current expectations for Fed rates to peak at close to 5 per cent, based on US overnight indexed swaps.

While fluctuations in currency markets spiked up last month amid fears of banking crisis, it is starting to subside again, becoming less of a threat to potential carry traders.

A JPMorgan Chase index of one-month implied volatility in EM currencies fell to 9.9 per cent this month, from as high as 11.1 per cent in the middle of March when banking tensions were increasing. A corresponding gauge of volatility in Group-of-Seven currencies eased to 10.1 per cent from 11.7 per cent.

The level of the two gauges is now almost equal after the EM index was twice as high as its peer at the end of 2021 – a reflection of the currency volatility caused last year by developed-market central banks.

EMs are set to maintain their interest-rate advantage over the US if the outlook for economic growth is anything to go by.

US growth will slow to 1.4 per cent this year and then to 1 per cent in 2024, according to projections from the IMF published in January. In comparison, growth in EMs as a whole will accelerate to 4 per cent in 2023, and then 4.2 per cent next year, IMF figures show.

The IMF is expected to issue its latest forecasts this week amid signs that the global economy is slowing.

“Our central scenario is for a mild US recession and a range-bound dollar, which should be supportive of the EM carry trade,” said Jon Harrison, managing director for emerging-market macro strategy at TS Lombard in London. The top targets for EM carry trades look to be the Brazilian real and Mexican peso, as these will be supported by proactive central banks and relatively high real interest rates, he said.  BLOOMBERG