(Bloomberg) -- By all appearances, this is a great moment for a popular currency trade in emerging markets.
Swings in foreign-exchange rates are moderate and interest rates across much of the developing world are high, a perfect co*cktail most of the time for fat returns in carry trades — transactions where investors borrow money cheaply in one currency and then funnel it into higher-yielding assets in another currency.
And yet, oddly, the trade is flopping right now. For the first time since 2006, the MSCI Emerging Markets Currency Index and JPMorgan EM Volatility Index have stopped moving in opposite directions, even showing a small positive correlation. That’s given rise to an unusual situation where volatility has sunk a four-year low, but developing currencies aren’t rallying. In fact, many are weakening.
Underlying the impasse is a series of push-backs in bets on when the Federal Reserve will begin cutting interest rates. This has effectively frozen investors, zapping volatility, as they remain reluctant to exit positions that stand to benefit from the Fed’s cuts, whenever they come.
“Emerging-market currencies have destroyed value,” said Luis Costa, a strategist at Citigroup Inc. “Volatility has fallen across asset classes, but not necessarily accompanied by flows.”
Local bonds are rallying in developing nations but their gains turn into losses when currency swings are taken into account. That has sent Bloomberg’s main gauge for local-currency EM bonds 0.4% lower this year. Carry trades are off to the worst start to a year since 2021 despite tantalizingly high interest rates.
Brazil offers a policy rate of almost 7% in real terms — meaning its official borrowing costs are that much higher than inflation. While this makes the country one of the year’s most popular carry trades, its currency has handed investors a 1.8% loss. From the Colombian peso to the Hungarian forint and the Indonesian rupiah, interest-rate arbitrage is a losing proposition.
Trend Reversal
Emerging currencies and their implied volatility have had a negative correlation for the past 18 years. For instance, a drop in the JPMorgan price-swings gauge in 2009, 2010, 2012 and 2017 coincided with rallies and an increase in volatility in 2011, 2013, 2014 and 2018 led to selloffs. This is a milieu traders understand well and use to their advantage to pick up extra yield.
Money managers began 2024 expecting swings to remain narrow as the options market, where the volatility measure comes from, exuded calm in the face of the then consensus the Fed would start cutting interest rates by March. But even as those bets have been pushed back to July, and the US dollar began drifting higher, volatility hasn’t come up. Indeed, implied volatility in emerging currencies has even plunged below that of their developed-market peers.
“Many seem relatively hesitant at the moment, perhaps waiting for some clarity on the Fed,” said Brad Bechtel, global head of foreign exchange at Jefferies LLC in New York. The strength of developed markets also makes further shifts to developing assets less palatable as “it’s hard to get too big there when ‘safer’ markets are ripping,” he said.
Even in developed markets, dollar-funded carry trades are losing money. That’s why investors are switching to funding with Swiss franc and Japanese yen and investing in dollar assets as well as other rich-nation currencies. Such a strategy has produced 3.4% returns this year.
Simon Harvey, the head of currency analysis at Monex Europe Ltd., said the options market was underplaying risks. “While we think this is the wrong view given the level of noise within the macro data, other late-cycle anxieties, and elevated level of geopolitical risk, it will likely take an exogenous shock to reignite the options market before the second quarter,” he said.
‘Still On’
Some emerging economies have started cutting rates, piling pressures on their currencies at a time the US moves toward a higher-for-longer stance. Hungary’s currency sank to a one-year low as the central bank — which pledged to slow the pace of easing — battles an angry government keen on jump-starting the economy through lower borrowing costs. Chile, the country that spearheaded the current easing cycle, has this year’s worst performing currency.
“The low volatility hunt for carry environment will stay with us for a while longer, but once the Fed or other Group of 10 central banks hit the easing button, that will likely change,” said Paul Greer, a money manager at Fidelity International in London. “For EM countries who attempt to speed up the easing cycle, we can expect to see some currency weakness.”
The good news for investors is that bets on emerging-market debt ahead of the Fed’s easing, touted by money managers including Grantham Mayo Van Otterloo & Co. as a “once-in-a-generation” opportunity, are seen working better when the US rate path becomes clearer.
“The local duration trade is still on,” said Guillaume Tresca, a global EM strategist at Generali Investments in Paris. “It is the FX component that has been suffering.”
(Updates with more context from the first paragraph)
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