Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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EM FX Carry Trade Update October 1, 2019
John J. Hardy
Chief Macro Strategist
Summary: Support for carry trades decelerated sharply over the last week as the US dollar firmed, though against the lowest yielding funding currencies like the Japanese yen, carry trades have just about managed to tread water in places. Further USD strength from here would begin to take the big dollar into new territory, so the USD outlook remains key for the EM currency outlook while yields are likely a bigger focus for the lowest yielding funding currencies.
Emerging market currencies have put in a weak performance this week, largely driven by a stronger US dollar, as the strength in the big dollar has generally spread across the board. We registered a modest pickup in risk measures as well, but sharply stronger bond yields just ahead of this report drove an interesting drop in some of the low-yielding funding currencies, especially the Japanese yen. Whether the USD continues to strengthen is likely the pivotal question for EM currencies, while the funding currencies will look more intently at the bond market to see if the recent spike in yields is an anomaly or could follow through - Japan's yields are the most volatile relative to their recent history as the country has implemented a new tax rate increase as of October 1, the large government pension fund is increasing the allocation for foreign bond purchases, and the Bank of Japan is seen as likely to concentrate on steepening the yield curve (mostly through rate cuts at the front-end it is assumed) or bringing some other form of easing at its meeting at the end of October.
Chart: Saxo Bank Global Risk Indicator
Our global risk indicator was knocked back from levels that are rarely sustained for any length of time (anything above 1) but are not yet cause for worry by any means, but the very recent bounceback of the last couple of sessions looks actually like a suspicious misread from our data provider for the EM credit spread component of our indicator index (we use a JP Morgan EM index) and we may look to replace that indicator because a more granular look at individual EM credit spreads suggests a sharp worsening rather than than indicator's improvement. Stay tuned.
Carry Trade Short Term Performance
We present the shorter term performance of higher carry currencies again this week to point out the general weakness in EM currencies against the hard charging US dollar. Leading the downside is the South African rand, likely due to the exuberance of the correction in precious metals markets this week, particularly platinum. Basically every currency in our EM universe was lower versus the USD over the last week save for the Philippine Peso and the risky Turkish lira is curiously doing its own thing versus the strong USD at the moment as well.
Carry trade performance*
The JPY and CHF have been the weakest currencies of late as US yields backed up a bit, but a very weak ISM Manufacturing print (released after this chart was created) could set bond yields lower, tending to support the lowest yielding currencies - more important US data is up later this week and the funding currencies will likely track the strength in bond markets.
The JPY and CHF have been the weakest currencies of late as US yields backed up a bit, but a very weak ISM Manufacturing print (released after this chart was created) could set bond yields lower, tending to support the lowest yielding currencies - more important US data is up later this week and the funding currencies will likely track the strength in bond markets.
Among higher yielding currencies, the 1-month returns have weakened versus the strong US dollar of late, with most higher yielders barely in positive territory for the month (and down on the week as we discuss above) after carry (though a bit more positive against the weakest funding currencies above).
Current carry available*
The chart below simply shows the forward carry for owning the USD versus (mostly negative yielding) funding currencies and the returns on higher yielding EM currencies versus the US dollar.Carry has become harder to come by in recent months as nearly every central bank globally in the tradeable FX universe is actively lowering rates.
The chart below simply shows the forward carry for owning the USD versus (mostly negative yielding) funding currencies and the returns on higher yielding EM currencies versus the US dollar.Carry has become harder to come by in recent months as nearly every central bank globally in the tradeable FX universe is actively lowering rates.
* 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.
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