Recent flare-ups in political risk in emerging markets weakened their currencies and helped send returns on carry trades tumbling from the highest in a year
New York/London: Currency traders basking in the relative calm of August markets just received a jarring reminder of the dangers of chasing high yields.
Recent flare-ups in political risk in emerging markets weakened their currencies and helped send returns on carry trades—borrowing in locales with relatively low interest rates and investing the proceeds in places where they are higher—tumbling from the highest in a year. Turmoil among South Africa’s political leadership prompted such a drop in the rand against the dollar this week that it cut the return on this quarter’s best carry trade in half from 10%.
Investors were already wary of adding to these strategies before Federal Reserve chair Janet Yellen’s address to the annual Jackson Hole conference on Friday. Her comments have the potential to deliver further pain to carry trades, whose world-beating returns have helped push an index of emerging-market currencies toward the first annual advance in four years.
“We’re once again reminded that emerging-market currencies are a volatile asset and subject to big swings over a short period of time," said Steve Hooker, the Hartford-based managing director of Newfleet Asset Management Llc, which oversees $11.5 billion. “Political risk is something you can never exclude when you deal with EM. The rally in developing currencies is at risk."
Newfleet has cut its exposure to emerging-market currencies to the “lower end" of its usual range of zero to 10% of its holdings, Hooker said. He cited the potential for the Fed to raise rates this year, the prospect of which has risen above 50% in the futures market following a string of hawkish comments from policy makers.
A UBS Group AG index of carry trades has fallen about 2% since reaching the highest in a year on 10 August. Deutsche Bank AG indexes show that, using Group-of-10 currencies, the trade has risen 5.3% this year, beating the strategies of buying and selling based on relative value and following trends.
Repelled by negative interest rates and bond yields from the euro region to Japan, money managers are plowing increasing amounts into developing economies, with emerging-market exchange-traded funds attracting more than $18.5 billion in a record 12-week winning streak. Yet currency volatility is rising from the lowest this year, potentially swallowing up the yield difference carry traders profit from. A JPMorgan Chase & Co. gauge of global currency volatility climbed to the highest in a month Wednesday.
The more than 4% drop in South Africa’s currency on Tuesday and Wednesday, as a feud between President Jacob Zuma and finance minister Pravin Gordhan intensified, halved the return investors got this quarter from selling dollars to buy rand, according to data compiled by Bloomberg.
“This is a wake-up call after South Africa rallied so much in the past month," said Peter Kisler, who runs an emerging-market fund at North Asset Management Llp in London, and has bet against rand-denominated bonds. “You could see people starting to reassess their exposure to emerging markets in September."
The escalation of political tension in South Africa on Tuesday was followed by S&P Global Ratings’ downgrade of Mexico’s credit outlook to negative, citing “disappointing" economic growth and a rising debt load. The news prompted the peso to extend losses.
South Korea’s won led Asian currencies lower on Wednesday after North Korea launched a ballistic missile test. In Brazil, suspended President Dilma Rousseff is facing an impeachment trial expected to begin this week and wrap up this month, adding uncertainty to the world’s best-performing currency this year. Investors in Turkey have in the last month been whipsawed by an attempted coup, a subsequent political crackdown and a potential downgrade from Moody’s Investors Service.
All of this is prompting traders to boost bets on an increase in marmket volatility. JPMorgan’s index of anticipated price swings in emerging-nation currencies rose to an almost two-month high of 10.2% on Wednesday in New York.
“Carry trades work until they don’t," said Win Thin, an emerging-market strategist at Brown, Brothers Harriman & Co. in New York. “A purely liquidity-driven rally is not going to last." Bloomberg
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