EM FX Carry Trade Update - January 2, 2020

Chart: Saxo Bank Global Risk Indicator
The flood of Fed liquidity in the form of a resumption of balance sheet expansion via T-bill purchases and massive new repo operations into year-end helped boost risk appetite at a pace never before seen in the history of our global risk indicator. For perspective, emerging market credit spreads dropped to their lowest level since before the global financial crisis in nominal terms and our measures of corporate credit are near the lows of the range since then as well. Meanwhile, broader market volatility and FX volatility in particular have been very low in the latter part of 2019, in FX to a record degree. Shortly put, we have entered uncharted territory in risk willingness.

EM policy rates over the last few years
The chart below shows the course of policy rates from the more liquid EM currencies with higher yields since EM currencies and risk appetite bottomed out, generally speaking and with some exceptions, in early 2016. A very different path for some currencies along the way – note the spectacular divergence of Brazil versus Mexico in 2016 – but virtually all of EM easing policy rates at the end of 2019, even those with the most fragile credit situations, like South Africa and especially the formerly crisis-hit Turkey.

Carry trade performance*
With a weak US dollar in Q4 and especially into year end, even the lowest yielders have traded firmly against the US dollar, with the exception of the Japanese yen, the one reliable funding currency lately besides the dollar itself. The UK election has seen a resurgence in sterling, meanwhile, that has made it unattractive as a funding currency.

Current carry available*
The chart below simply shows the forward carry for owning the USD versus funding currencies and the returns on higher yielding EM currencies versus the US dollar. The interesting question for 2020 is to what degree EM assets can maintain a bid from investors abroad as the inflows of capital and the easing policy rates have done little to nothing to boost growth over the last year. An example is the Russian ruble, as the Russian economy continues to limp along with sub-2.0% growth while the currency realized an eye-watering 22% carry-adjusted return versus an evenly-weighted basket of the four lowest yielding G10 currencies in 2019. With less and less carry available, the risk/reward from current levels has fallen sharply.

*Note that all performance calculations are done as carefully as possible to include trade spread costs and market conditions at the time but actual results will inevitably vary depending on the timing of rolling forward positions and other factors.