America – the next big game for carry trade?
Carry Trade is an investment strategy which occurs when an arbitrageur adopts a short-position with regards to one low-interest rate currency, while he simultaneously takes a long position on another, high-interest rate currency. In a post-2008 world, the principal gamble of carry trade arbitrageurs was to exploit the interest rate differential between the U.S and the Emerging World.
In the aftermath of the 2008 financial meltdown, the Federal Reserve set the Federal Funds Rate between 0% and 0.25%. This meant it was profitable for arbitrageurs to borrow in U.S. Dollars (USD), at very low interest rates, and lend in higher-yielding currencies, particularly in Emerging Markets (EMEs). In the same period, for example, the Bank of Mexico had set the reference interest rate at 4.5%. Profits were certain.
Money began to pour in to EMEs. In the period in question, total portfolio flows into Emerging Market financial assets doubled from about $4 trillion in 2008 to over $8 trillion in 2012. Major bond funds’ allocation in EMEs increased six-fold, from 2% in assets under management (AUM) before the crisis to over 12% in late 2011. The waves of capital inflows flooding local markets pushed the real exchange upwards, tempting several governments, corporations and other borrowers to over-leverage, while authorities kept monetary policy loser than they would have otherwise done. EME sovereign and corporate debt issuance rose from $144 billion in 2007, to $330 billion issued in 2012; an increase of almost 230%. However, as soon as possible plans by the Fed to end its Quantitative Easing (QE) program began, a tapering tantrum ensued. The vulnerability and dependence of EMEs to capital inflows began to show, as a vacuum effect ensued. Capital reversal was beginning to occur.
Now, the U.S has, it seems, successfully conquered the road to recovery. Tapering has been successfully carried out, and while interest rates have not yet risen significantly, it is only a matter of time before they do. All indicators seem to show that quite soon, the US will be in shape for the Fed to do the last necessary bit of normalization. The USD has appreciated by some 6% in real effective terms relative to October, 2014. Meanwhile, the U.S economy in general has exceeded all expectations and is expected to exceed 3% this year, partially due to the increase in oil prices, an increase in domestic demand, moderated fiscal adjustment and continued support from accommodative monetary policy. These factors are likely to be only partially offset by reductions in net exports caused by the appreciation of the dollar.
A stronger U.S is certainly a threat to carry trade. Or is it?
The current international financial situation continues to be particularly complex and uncertain. The world economy has continued to show signs of weakness. While the U.S is doing particularly well, the same cannot be said of other advanced economies. The possibility of stagnation and low inflation in Europe and Japan means that monetary policy there is likely to continue to be quite lose going forward. The ECB has already announced its own quantitative easing program in an attempt to boost up prices and reanimate the economy of the Eurozone. Both the Eurozone and Japan have diminished economic prospects for the future. Their currencies show as much: The euro has depreciated by some 2% in in real effective terms relative to October, 2014, while the yen has depreciated by up to 8%. With low-interest currencies in Europe and Japan, there is still an important push factor for carry trade to continue.
Diminished expectations in the world economy and lose monetary policy in two G4 countries could signify an important factor in favour of the persistence of the carry trade. With long term government bond yields declining further in most advanced economies, it is still possible for investors to invest capital which they can borrow at low interest-rates currencies, such as euros and yen, and invest them in higher yielding EME currencies.
However, the situation has changed, somewhat. To begin with, there is now more aversion to risk amongst investors. The decline of long term government bond yields in many advanced economies is a reflection both of safe-haven effects as well as of the weaker economic activity which we have already signalled. A sign of this increased aversion to risk can be seen in the reaction of investors to the recent and unexpected news by the Schweizerische Nationalbank (SNB) that it would end the cap of the franc, long seen as a safe-haven currency. In a matter minutes, the franc appreciated by over 35%. Meanwhile, the price of gold has also increased from 1,180 $/oz at the beginning of the year, to 1,320 $/oz today. It should be noted though, that the price both of gold and the franc reached much higher levels in 2011.
A much more significant – almost seismic – change for carry trade is that EMEs have become less attractive investment prospects, and are likely to be even less attractive in the future. The “push” factor is still there, in Europe and Japan. However, it is only cyclical and will diminish in the next decade. The “pull” factor on the other hand, is subsiding.
Similarly to their counterparts in Europe and Japan, EMEs are also experiencing a downside risk with regards to economic growth, related to a shift in sentiment and increased volatility in global financial markets and by changes in commodity prices. A dip in oil prices by over 55% since the third quarter of 2014 has caused balance sheet vulnerabilities for oil exporting-countries. This has meant that - particularly amongst commodity exporters - risk-spreads and interest rates have risen. Also, many EMEs are likely to also have disappointing results in terms of growth. Asian EMEs are likely to be affected by the lower growth in China, where there is likely to be further slowdown in investment. The IMF outlook for China has fallen from 7.8% in 2012 to a prediction of 6.8% for 2015; many other emerging market Asian countries have similar results. Russia is similarly affected by the fall of oil prices and the increase in Geopolitical tensions, effects which will have contagion on CIS states. Other commodity exporters face tough times ahead, as the impact of the fall of commodity prices will have effects both on Terms of Trade and real income which will take a heavy toll of medium-term growth.
Events in the U.S will continue to have a toll on many EMEs. A few countries such as Mexico, which is commercially tied to the U.S, may reap the rewards of an economic recovery there. For most countries however, the effect of an upward tendency in long-term U.S. interest rates, may prove to be quite negative. Higher long term bond yields will impact EME debt denominated in U.S dollars, creating upward pressures on marginal funding costs of local governments, corporations and other borrowers. Fortunately, dedollarization of debt in the last decade, will act as an offset. Nevertheless, it is likely that higher U.S bond yields lower the attractiveness of investments in other currencies. This will force a rise in long-term bond yields across EMEs. Simultaneously, lower equity prices in EMEs in the wake of the interest-rate shock are likely to lead to a contractionary impact. On the other hand, pressures will be exerted on EME exchange rates, which in turn might cause inflation and increase Current Account Deficits. A repeat of scenarios such as the Mexican peso crisis (1994) or the emerging market crises of the late 1990s, although not necessarily probable cannot entirely be ruled out.
However, with a weak world economy on the one hand and a strong U.S economy with bright prospects for the future and higher future yields, it is not likely that the next big gamble for carry-trade is to invest in the U.S? Yields, without a doubt, are much lower than in EMEs, but that is only a sign of how safer an investment the U.S is. Undoubtedly, there will be arbitrageurs willing to play the riskier gamble and continue to invest in increasingly vulnerable EMEs, even if the chances of losing millions are increasingly decked against them. There are still, after all, people willing to invest in the short-term in Argentina because of its high yield. However, any increase in the risk premium of EMEs has pushed investors out, not pulled them in. Many investors are likely, therefore, to like to invest in USD, which is likely to see a bull-run in the future. Thus perhaps, the next big swing for carry-trade is borrowing in euros and lending in dollars.
IMF World Economic Outlook (2015)
IMF World Economic Outlook (2013)
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