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 - January 2, 2020
John J. Hardy
Chief Macro Strategist
Summary: There was maximum support for emerging market currencies into the end of 2019 on the liquidity pumping from the US Fed. But we sound a note of caution on EM currencies as 2020 gets under way as the rate of change of USD liquidity provision will slow rapidly in 2020 as reserves are deemed plentiful and as the end-of-year issue is behind us.
The US Federal Reserve’s liquidity provision into year-end and expansion of its balance sheet from the August 2018 lows by over $400 billion finally saw a more marked effect on the US dollar into year-end as the Fed joined the other G3 banks (BoJ and ECB) in providing balance sheet expansion. Providing further support for what already seems as-good-as-it-gets conditions, the Chinese central bank chopped banks’ reserve requirement ratios 50 basis points at the beginning of the year to support the economy there and the lowering of the USDCNY rate to well below 7.00 suggests China is happy to support its currency in this environment as it is set to sign the “Phase One” trade deal with the US soon.
One small note of caution on the emerging market outlook that we have noted before is the degree to which emerging market policymakers have taken advantage of their popularity and the reach for yield to lower their policy rates. With relatively weak growth levels in most of these economies, we are presented with an unusual situation in which the inflows are not associated with any massive new boom in credit as was the case in the wake of massive Fed easing in 2008-09 and at other times in the past. If the global growth outlook doesn’t begin improving in the New Year, further upside may prove rather limited and downside volatility more aggravated if animal spirits weaken.
EM Carry trade performance in 2019
Below is a snapshot from a Bloomberg tool for measuring FX carry performance. We chose the four highest yielding of the more liquid emerging market currencies at the beginning of the year versus the four negative yielding G10 currencies (with SEK now the odd one out, having hiked to zero at the end of 2019!). We can see that EM FX carry traders had a banner year in 2019 with a single leverage return on this carry basket of nearly 15%. With 20-20 hindsight, this shouldn’t be a major surprise, given the spectacular returns for the year across risk assets in general and the rush lower in the USD in the final weeks of the year.
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.
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