History says emerging market’s carry trade can only end in tears
MOSCOW: Investors reaping handsome returns on emerging-market currencies this year might do well to heed a warning once made by Harvard economist Jeffrey Frankel, who likened carry trading to “picking up pennies in front of a steam roller.”
Economic theory – and history – suggest the strategy of borrowing where interest rates are low to invest in high-yielding currencies is prone to the risk of a sharp reversal when too many investors pile into the trade. Strategists at Bank of America Merrill Lynch (BoA) warned last week that sentiment on emerging-market currencies is already reaching “exuberant levels.” Rabobank’s chief currency strategist says now is the time to take profits.
Investors from BlackRock Inc to Man Group Plc have poured money into emerging-market currencies this year to profit from interest as high as 12% compared with rates close to zero in the US and European Union. The strategy has produced an average return of 7.5% since the beginning of the year, according to the Bloomberg Cumulative FX Carry Trade Index that tracks eight major currencies against the dollar.
“Carry trades are notorious for risk-off unwinds, especially when positioning is crowded and correlated,” strategists at BoA including David Hauner said in the e-mailed research note. Sentiment “is approaching levels at which a correction is historically frequently followed,” they said.
Hauner and his colleagues based their findings on BoA’s Emerging Market CarrySentiment Indicator, which measures the level of investor bullishness by analysing flows into fixed-income and currency markets. The gauge shows carry sentiment is approaching a level that has historically preceded a correction within four weeks.
Among the currencies surveyed, the ruble is “by far the most consensus trade” in Eastern Europe, the Middle East and Africa, and BoA is using options to bet the Russian currency will decline amid oil-price fluctuations, according to the note. Meanwhile, the possibility of a “showdown” in South Africa between President Jacob Zuma and his opponents has prompted the bank to short the rand versus Turkey’s lira.
Global emerging-market debt funds have attracted inflows for a 17th straight week this year, taking the total to more than US$33bil, according to EPFR Global data. A BlackRock exchange-traded fund that tracks emerging-market local currency debt has lured more than US$2bil, nearly doubling its size.
Analysts at Goldman Sachs Group Inc and Barclays Plc say low volatility in developed markets, coupled with a weak US dollar, will continue to support attractive conditions for the carry trade to continue. Emerging-market currencies are “modestly undervalued,” Goldman strategist Kamakshya Trivedi said in an e-mailed note last week, which recommended buying the Mexican peso and South African rand. — Bloomberg