The stars are aligning in favor of a popular foreign exchange that benefits from attractive returns and low volatility, even when the mMarkets are coming out of one of the most turbulent months in years.
The signs that the US economy is slowing down and global interest rates are peaking are paving the way for investors to revive so-called carry trades in emerging markets, which involve borrowing in lower-yielding currencies to buy higher-yielding ones.
He International Monetary Fund predicts that developing economies, especially in Asia, they will be a bright spot even as the US slows down, so it seems that for the first time in years the right ingredients are present for this strategy to be successful.
Black Monday for the global economy due to the crisis of the United States banking system
A Bloomberg gauge that measures dollar borrowing to put funds into a basket of emerging currencies has returned nearly 5% this year, rebounding from three years of losses to the highest level since 2021.
Last month, performance outperformed an index of developed markets as ethe fear of a banking crisiswhich started in the US, reinforced bets that the Federal Reserve is near the end of its monetary tightening cycle
“Counterintuitively, the episode of March financial market volatility it could be the key to reviving carry trades in emerging markets,” said Eimear Daly, emerging markets strategist at NatWest Markets Plc in London. “Now that the US carry is likely to be constrained, investors will be tempted to return to high-carry emerging market currencies, with a significant carry bid.”
Interest in carry trades has picked up as rapid policy tightening by major central banks appears to be coming to an end amid growth concerns. That has been enough to build confidence in this strategy, despite the volatility in the currency markets, which can hurt potential returns.
“Emerging market currency returns hold up well in US-centric downturns, and carry strategies are starting to look interesting again”, according to a note from Citigroup Inc. strategists, including Adam Pickett, published Thursday. “Emerging market fixed income and equities could continue to struggle and EMFX could be a better place to hide.”
Operations financed in dollars with money put in the currencies of Hungary, Colombia and Mexico have returned more than 6% this year, according to data compiled by Bloomberg. Seventeen of the 23 emerging market currencies tracked have delivered positive returns so far in 2023, while most have lost money last year, according to data through Friday.
Several emerging market currencies are especially attractive carry targets, as their central banks raised interest rates to fight inflation before their developed counterparts.
“Most emerging countries have raised rates significantly, many of them before the Fed and more, so many emerging market yields are attractive,” says Rajeev De Mello, a global macroeconomic portfolio manager at GAMA Asset Management SA in Geneva. Attractive target currencies for carry trades include those of Brazil, Mexico, India, the Czech Republic and Poland.
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Brazil’s central bank began raising rates in March 2021, and did so by a total of 1,175 basis points, up to the current level of 13.75%. The country’s Selic rate offers an 875 basis point premium over the Fed’s benchmark, a sizeable cushion to offset any potential weakness in the Brazilian real.
Benchmark rates in Brazil, Mexico, Colombia and Chile stand at 7% or higher, well above current expectations for Fed rate ceilings near 5%based on US overnight indexed swaps.
decrease in volatility
Although fluctuations in the currency markets spiked last month on fears of a banking crisis, they are beginning to subside again, becoming less of a threat to would-be carry traders.
And JPMorgan Chase & Co. Implied Volatility Index one month in emerging market currencies fell to 9.9% this month, from a peak of 11.1% in mid-March, when banking tensions were rising. An equivalent indicator of the volatility of the currencies of the Group of Seven decreased from 11.7% to 10.1%.
The IMF expects 5 years with a global growth of 3%, well below the average of the decade
The level of both indicators is now almost equal, after the emerging markets index doubled that of its peer at the end of 2021, reflecting the currency volatility caused last year by developed market central banks.
Judging by the outlook for economic growth, emerging markets will maintain their advantage over the US on interest rates.
According to the projections of the International Monetary Fund pPosted in January US growth will slow to 1.4% this year and 1% in 2024. By comparison, growth in emerging markets as a whole will accelerate to 4% in 2023 and 4.2% next year, according to IMF figures.
The IMF is expected to release its latest forecasts this week amid signs that the global economy is slowing.
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