February 10, 2015 3:09 pm
EM bond allure fades as US rate rise looms
Jonathan Wheatley
Are we watching the last gasp of the carry trade? Yield-hungry investors have again been borrowing cheaply in developed markets and investing the proceeds in high-yielding emerging markets such as Turkey, where 10-year local currency government bonds, for example, offer yields in the high single-digits.
The emerging market carry trade has a proud history and has made the fortunes of many an EM specialist. They gained not only from generous yields on EM bonds but also from the winnings on EM currencies. Many of these appreciated steadily against the US dollar before and after the global financial crisis, driven by money pulled into EM economies by their fast growth and latterly pushed in by the tide of central bank bond buying, known as quantitative easing.
But the commodities supercycle and the US Federal Reserve’s QE programme are over and emerging market investors face a less certain world. Take Turkey. When the price of oil fell last year, Turkey was spotted as a winner. It has struggled for years with a current account deficit consisting almost entirely of energy imports. Cheap oil would ease that pressure, help tackle inflation and give a boost to consumer spending. Investors piled in. Yields (which move inversely to prices) on Turkey’s 10-year local currency bonds fell from about 9.8 per cent in September to about 6.8 per cent last month.
But the benefits of cheap oil were not enough to prop up the Turkish lira. It did strengthen periodically as carry traders came in, but over the past year it has been on a steady path of weakness.
Analysts blame severe political pressure on the central bank to cut interest rates even though inflation has failed to fall as much as expected. This month, the lira has gone from about 2.28 to the dollar to about 2.48 — a body blow to the earnings of carry traders. Bond yields have retraced to about 7.8 per cent.
“The lira remains vulnerable,” says Luis Costa, a strategist at Citi Research. “Given the inflation dynamics and the pressures on the central bank, you have to be a lot more cautious.”
Turkey is far from alone. In Brazil, previously a carry trade favourite, the real has begun to undo years of gains against the dollar as the country has failed to deliver its promise of growth and investors have lost faith in the government’s ability to turn the economy round. The central bank’s interest rate is expected to stay high over the next year. Even after discounting expected inflation, real returns look generous. But investors are nervous — not least because of a corruption scandal unfolding at Petrobras, the state oil company — and the real has devalued sharply against the dollar this month.
There are similar stories elsewhere. If we net inflation expectations (a proxy for currency fluctuations) out of expected interest rates in other carry trade countries, the returns rarely match the risks. In China, for example, foreign funds are flooding out.
“The heydays of the carry trade are largely behind us,” says Aroop Chatterjee, a currency strategist at Barclays. “A lot of funding was in dollars and with US interest rates potentially heading higher, the carry is less attractive. Although interest rates have risen in some emerging markets, most are under pressure of slower growth and falling inflation, so they will cut, and that puts downward pressure on their currencies and reduces the attraction.”
Carry traders have not given up yet. The European Central Bank has taken up the QE baton, providing an alternative source of funding. Simon Quijano-Evans, a strategist at Commerzbank, says bond markets in countries such as Austria, the Netherlands and even Germany may dry up under ECB QE, leaving pension funds and others looking elsewhere for investment opportunities. But yield is already hard to find.
“If you look at yields in places like Poland and even Hungary, they have come down to historically low levels,” he says. He points to the price of credit default swaps, a form of insurance against default, which for many emerging markets are already on a par with those in developed markets. “In terms of spread compression, we are really there already.”
Mr Quijano-Evans says carry traders have an opportunity between the start of ECB QE and when the US Fed starts raising interest rates, probably in the third quarter. Even in a low-yield environment, he says, investors will keep EM local currency bonds in their portfolios. And he expects them to keep moving in and out of riskier markets such as Turkey, Brazil and Russia. But for the carry trade as it used to be, “there are just too many moving parts blowing the story”.
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