EM FX Carry Trade Update October 31, 2019

Carry Trade Short Term Performance
The shorter-term performance of EM currencies remains generally very positive over the last month, but the last week has seen a smaller contribution as risk conditions suffered a bit of a stumble after the FOMC meeting. BRL was the star performer over the last week as it has accomplished a major pension reform deal that will markedly improve the budget sustainability. ZAR and CLP are sharply lower on idiosyncratic reasons – ZAR we discuss below and CLP due to disruptive protests and the risk that the country will have to widen deficit spending to respond to public demands. With a policy rate below that of the US, holding CLP offers nothing in the way of carry rewards for traders unless it is held versus an even lower yielding funding currency.

A snapshot of specific EM credit spreads
The chart below shows a snapshot of the credit spreads for four EM currencies’ USD bond and their US counterparts over time and relative to the USD exchange rate. Most EM currencies have seen tightening credit spreads as financial conditions have been very favourable – supporting the recent strength in EM. But South Africa’s credit spreads have taken a sharp turn for the worse here after it recent published its latest budget, which will include very large costs linked to shoring up troubled power provider Eskom, a move that has prompted fears that South Africa’s debt could be downgraded and triggering a sharply weaker rand this week.

Carry trade performance*
Among the funding currencies, the JPY has been the best behaver in remaining weak against the broad market – at least until its strengthening move in the wake of the FOMC meeting. Sterling has been a funding currency to avoid as hopes that a path to a soft Brexit remain on track and No Deal is unlikely have fed a considerable rally - though it could be faced with a flat period from here as we await for the December 12 election result.

Among the EM currencies, most have turned the corner over the last month from prior weak performance, including BRL noted above. We are writing this report with USDCLP at a new 15-year high.

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. Note the further collapse in carry available for TRY longs after the recent massive 250 basis point rate cut and more likely on the way, provided TRY is stable. Brazil cut its policy rate this week by another 50 basis points from the old record low to a new one of 5.00%.