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 31, 2020
John J. Hardy
Chief Macro Strategist
Summary: The coronavirus outbreak has brought a broad setback for EM currencies, and especially those currencies exposed to commodities like copper and iron ore that have been heavily sold on fears of extended supply disruptions and demand from China. We continue to urge a very defensive stance on EM currency exposure.
The EM currency space has stumbled badly on the outbreak of the coronavirus in China, which has impacted risk appetite, but many select commodities even more so since the story picked up attention in the market starting less than two weeks ago (using copper as our benchmark – and even if it feels like this story has been driving the narrative for even longer). We really don’t know where this situation will take us, but the issue is the most important one in the driver’s seat until it is firmly behind us. On that note, a couple of points are foremost in our mind.
Coming into this virus outbreak, the EM complex and financial conditions could not have been more complacent, suggesting rather significant risk that significantly more volatility awaits if the concerns and fallout from the issue worsens. Secondly, conditions themselves, especially emerging market credit spreads (still near post-GFC tightness), are only beginning to show a bit of concern here and there, even as select commodity prices are flashing deep red - so again, the market has mostly downshifted from extreme levels of complacency and isn’t yet showing any pronounced risk aversion. On that note, we upgrade our concern level for now and urge a very defensive stance on EM-related risk.
YTD EM Carry trade performance in 2020.
Below is a snapshot from a Bloomberg tool for measuring FX carry performance, a snapshot we will release with every update this year for a sense of how carry trades have performed in broad terms. Of course, the given basket here is for the most liquid of the higher yielding EM currencies and is more than a bit light on China-exposure, the most important theme of the moment. Still, our other performance snapshots below should give an idea of what themes are out- and underperforming.
For this basket, we chose the four highest yielding of the more liquid emerging market currencies at the beginning of the year versus the four lowest yielding G10 currencies. This basket returned nearly 15% in 2019 due to that year starting at a very low point for global risk appetite. After a strong start to 2020 on an extremely supportive backdrop in financial conditions, today is seeing the basket turn negative (-0.7% as per the blue line) on the year. Note that we used the MSCI EM equity index in USD terms as the benchmark – a benchmark that looks high beta in return terms relative to the basket so far this year.
Short term EM currency performance
The below shows the 1-week and 1-month carry-adjusted performance of the EM currencies in our universe and really paints a picture of how deeply EM currencies have corrected here in the short term, with commodity currencies like the Chilean peso (often considered a copper proxy) most heavily affected, as well as many of the China-exposed exporting economies’ currencies, from Malaysia to Singapore and Korea.
Chart: Saxo Bank Global Risk Indicator
As noted above, risk conditions have mostly simply mean reverted here and are still rather far from flashing red – especially in the case of emerging market credit spreads. Given how badly EM currencies have stumbled merely on some mean reversion, we hasten to warn that performance can deteriorate much more sharply if our risk indicator plunges deeply into the red in coming days/weeks.
Carry trade performance*
The chart below shows the longer term performance of the US dollar versus the lowest yielding funding currencies. The performance of funding currencies has picked up solidly over the last couple of weeks with the exception of the more cyclically-inclined SEK as traders are likely unwinding some of their EM longs against these currencies as well as against the US dollar.
EM currency performance continues to vary widely in the longer term, and the shorter term performance is more interesting above due to the very recent advent of the coronavirus effect in market returns, but still note in the graphic below the contrast in many cases between weak 1-month returns relative to the longer term performance. Russian ruble and South African rand traders have been administered quite a dose of whiplash over the last few weeks.
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. Given the very poor performance of EM currencies on the coronavirus outbreak, we doubt that some of the projected interest rate cuts that were recently expected from EM central banks, including in Brazil and Russia, will come to see the light of day.
*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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