InvestmentsOct 14 2014

News Analysis: Carry trade feels the heat

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Fears have risen in markets recently that the multibillion dollar carry trade feeding the flood of investment into higher-yielding emerging market debt could be set to reverse.

The JPMorgan EMCI index, which is a gauge of emerging market currencies, recently plunged to its lowest point against the dollar in 11 years.

The carry trade, whereby investors borrow in a low-interest currency, such as the dollar, to invest in higher-yielding assets, such as developing market debt, is under pressure as falls in many emerging market currencies against the dollar are exceeding the gains from the interest rate differential.

But what do market strategists and multi-asset managers think about how the market could turn?

John Ventre, portfolio manager at Old Mutual Global Investors, disputes the suggestion that investors have been excessively leveraged, saying the significant flows into emerging market debt have been “real money” – typically pension funds seeking to diversify their asset allocation away from expensive US government bonds.

He says the consensus position among hedge funds looks to be long on the dollar and short on emerging market currencies and that currency moves are being driven by dollar strength. “When looking at emerging markets on a trade-weighted basis, the moves are less dramatic,” he says.

Eugene Philalithis, Fidelity Multi-Asset Income fund manager, says he is also sanguine because, while the dollar has appreciated against most emerging currencies, the carry trade is now more attractive than it was before the summer.

“US Treasuries are yielding less, while emerging market debt is yielding more and this should act as a tailwind for emerging market foreign exchange,” he claims.

Zsolt Papp, a member of JPMorgan Asset Management’s emerging market debt team, points out that not all emerging market currencies have depreciated by the same amount against the dollar.

“The Brazilian real lost 9 per cent whereas the Mexican peso lost only 3 per cent in September, which illustrates how important it is to differentiate in the current global market environment,” he says.

That said, he is monitoring the dollar and its impact on emerging market currencies, as he cannot rule out a repeat of the May-June 2013 global market correction.

He says the evidence so far suggests that further gradual appreciation of the dollar would probably not be sufficient to spark a similar sell-off. “We believe that something else would be required to trigger a large-scale reversal of the emerging market carry trade, such as an unexpected hike in US Treasury rates,” he says.

Andrew Milligan, Standard Life Investments’ head of global strategy, says emerging market valuations have appeared stretched for some time, particularly in longer-duration assets, leading him to take a neutral stance towards local currency debt.

“For some countries, the poor fundamentals have diverged from generous funding conditions, thus raising concerns,” he explains. “However, investments in emerging markets have reflected a broader reallocation of capital seeking yield in a stable class that has matured dramatically over the past decade.”

He says the investor base has also broadened out to euro- and yen-based investors and to a wider class of asset managers, with many of these newer participants being real money managers and not classic leveraged, short-term carry traders.

So are investors exiting emerging market debt, or are they moving into dollar-denominated emerging market debt as opposed to local currency debt?

Mr Papp says renewed concerns about the dollar strengthening and US Federal Reserve policy tightening, led to a slowdown of local currency emerging market debt flows in September, whereas emerging market hard currency bonds continued to attract inflows.

He says flow data also indicates that investors preferred Asian and Latin American currencies over central and eastern European currencies, but that the numbers do not suggest investors are reallocating assets from emerging market local to hard currency bonds on a large scale, partly because emerging market hard currency valuations are less compelling.

“We also believe that investors are hedging some of their local currency exposure,” Mr Papp says. “This effectively reduces portfolio yield, but enables investors to benefit from the uneven dollar appreciation by taking emerging market foreign exchange positions against currencies other than the dollar, such as the euro.”

So what is causing emerging market currencies to fall against the dollar and how is this affecting investors’ currency trading strategies?

Mr Ventre says there is an historical correlation between dollar strength and weakness in emerging market currencies, which is typically caused by rising rates in the US attracting capital ‘back home’ to more attractive local assets.

“This cycle is likely to be different this time because US rates are not rising to 5 per cent plus, but most likely only to 2-2.5 per cent, and we believe that the quantum of US interest rate rises is more important to the fair valuation of emerging market debt and currencies than the direction of movement,” he says.

“As a result, we see the recent weakness in the asset class as a buying opportunity and we have been adding to our exposure recently.”

Mr Papp notes that the recent trading pattern suggests commodity-linked currencies, or those from countries with significant external and/or fiscal imbalances or fragile growth prospects, had fallen more than currencies supported by sound macroeconomic balance sheets or solid growth outlook.