(Bloomberg) — For decades, carry traders have borrowed US dollars at low interest rates and invested in higher-yielding emerging-market currencies. But that flow is now getting turned on its head.
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The Federal Reserve’s tight monetary stance has extended for so long that some emerging economies are struggling to keep their yields competitive, making them the target of a so-called reverse carry trade. That trade is paying off. Borrowing in emerging-market currencies and buying the dollar has produced returns of as much as 9% this year.
The Chinese yuan, Thai baht, Malaysian ringgit and even Czech koruna are some of the currencies being used. That’s not to say the traditional carry trade is dead: it’s still being used to invest in high-yielding currencies such as the Mexican peso, Turkish lira and Egyptian pound, but even those trades are increasingly being funded by the Japanese yen, Swiss franc or other EM currencies, rather than the dollar.
“We like owning the US dollar against Asian currencies,” said Paul Greer, a money manager at Fidelity International in London. “We like using low beta, low-yielding Asian currencies as funders, as well as the euro and Czech koruna where we are similarly pessimistic on the growth outlook.”
Investors have pushed back forecasts for US rate cuts from March all the way to December, making monetary easing by some developing nations look premature. It also means that carry traders who used the dollar to fund their EM exposure are making the deepest losses since 2021, finding themselves holding riskier currencies that offer smaller or negative returns.
The hit to the traditional carry trade is coming from two main factors: currency moves and yield differentials. The dollar’s resilience in the face of a robust US economy and tighter-for-longer monetary environment has pushed 29 of the 32 most widely traded EM currencies into losses this year. At the same time, benchmark borrowing costs in at least 11 frontier and emerging nations are below US policy rates — dragging relative bond yields into negative territory.
“Now you have to pay to own currencies in these countries including China, Taiwan and Korea,” said Manik Narain, head of EM strategy at UBS Group AG. “While Asia is dominating the negative-carry theme, the carry buffer is slipping in some other pockets of EM too.”
UBS is recommending shorting the yuan against the dollar as Narain expects Beijing to allow the currency to depreciate to gain back some of the country’s export competitiveness, which has been eroded by a cheaper Japanese yen. That could, in turn, depress EM currencies as a group, driving more carry flows in the opposite direction — toward the dollar — he said.
It’s not just speculators but also exporters who are now favoring the dollar for its higher yield, according to Simon Harvey, head of FX analysis at Monex Europe Ltd. Over the last several months, the currency house says its clients have parked their revenues in dollar deposits and refrained from converting them back into their home currencies.
“Long dollar as the investment leg is starting to provide better risk-adjusted returns relative to other popular receivers like the Mexican peso and Brazilian real due to the defensive attributes the dollar holds,” Harvey said.
A hawkish pivot in emerging markets could still give respite to dollar-funded carry trades, as long as Fed easing expectations aren’t pushed back further. For now, money managers are divided on the outlook for both carry and currency moves for the rest of the year and prefer to remain tactical.
Citigroup Inc. and JPMorgan Chase & Co. are touting a brighter path ahead for the riskier currencies either from a slowdown in the pace of interest-rate cuts or a rebound in oversold currencies.
UBS, on the other hand, expects EM currencies to continue to lag the dollar and advises investors to fade any rallies. While strong consumer spending in the developed world has forced central banks to lean hawkish, consumption-led demand isn’t filtering through to global trade, depriving emerging markets of the growth momentum needed to support their currencies, according to Narain at UBS.
“EM currencies have the worst of both worlds,” he said.
What to Watch
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PMI figures due from China on Tuesday will set the tone for emerging-market trades linked to growth prospects in the world’s second-biggest economy
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At least 12 emerging and frontier nations including South Korea, Poland, Kenya and Vietnam will report their latest consumer-price-index figures
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Hungary, Czech Republic, Taiwan, Tanzania and Latvia are among countries reporting GDP
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Brazil will report FGV inflation, budget balance and weekly trade balance figures on Monday, national unemployment rate Tuesday
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Chile will disclose retail sales, unemployment and industrial-production and copper-output data, which may signal if the peso can extend its April gains to a second month
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Export-import data from South Korea, Thailand, Vietnam and Turkey will show the health of global trade on the back of a robust US economy
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