Emerging currencies are in ‘sweet spot’ for carry trades again

Policy makers in Poland, Russia, Peru and Malaysia are all due to set borrowing costs, safe in the view that U.S. rates will remain low for longer, a message that Fed Chair Jerome Powell hammered home at Jackson Hole. And it means that any hawkish turn in emerging markets could bring the carry trade back into play, supercharging gains, as was the case for the Chilean peso last week.

While the emerging-market carry trade returned just 0.5% in the first half, Bloomberg’s EM Carry Index is already up almost 2% since the end of July, with high-yielding but volatile currencies such as Turkey’s lira and South Africa’s rand leading the charge.

“Emerging-market currencies may be in a sweet spot,” said Christopher Shiells, an analyst at Informa Global Markets in London, who backs Brazil’s real, Russia’s ruble and the Mexican peso to outperform in the coming months.

Friday’s weak U.S. employment data underscored belief that the Fed will hold rates even as it begins to scale back emergency stimulus. That would keep the cost of borrowing dollars to park in higher-returning securities low, a strategy that could serve investors particularly well given that the Fed’s focus on nurturing the economic recovery will also keep a lid on the greenback.

“Powell, at least at this juncture, seems to have managed a pro-EM taper  — something we never thought we would see,” said James Barrineau, head of emerging-market debt at Schroder Investment. “The key thing Powell did was to forcefully separate the taper discussion from the rate hike discussion. He indicated rate hikes are probably a long way away. That has resulted in a weaker dollar which is a strong positive for EM.”

The decoupling of tapering from rates has also given a new lease of life to the currencies of early hikers like Brazil and Russia, whose outperformance had been starting to wane following aggressive gains this year. The ruble and real have been among the top performers in emerging markets since Powell’s Jackson Hole speech on Aug. 27, which gave policy makers room to react to economic fundamentals rather than second-guessing the Fed.

“EM central banks have already reacted to higher inflation and raised interest rates, creating a buffer should economic growth start to surprise on the downside next year,” said Anders Faergemann, a money manager at PineBridge Investments in London, who described Powell’s Jackson Hole speech as a “game changer.” With inflation in many developing nations close to peaking, “these countries have positive real rates already which would tend to support the exchange rates,” he said.

That may be just the start. The ruble’s volatility-adjusted implied yield, for example, has climbed more than 200 basis points to a 20-month high following a rate increase in July, with another expected this week. And while implied yields fell across emerging-market regions in the past month, they’re already showing some recovery in Asia and Latin America.

As the carry trade roars back, investors may find yields in countries such as South Africa, Brazil and Turkey too juicy to resist, bolstering their currencies, said Michel Vernier, head of fixed-income strategy at Barclays Private Bank. Export- and commodities-linked currencies are also expected to get a boost.

These are the events to look out for this week:

• China’s trade figures for August, due on Tuesday, will give further clues on the economy’s slowdown following the release of soft purchasing managers’ index gauges. Exports likely moderated due to interruptions in supply chains with the resurgence of Covid-19, according to a note from Australia & New Zealand Banking Group Ltd.

• South Africa’s battered economy probably rebounded 17.8% year-on-year in the second quarter, data may show on Tuesday.

• Malaysia’s central bank is likely to keep its benchmark interest rate at a record-low 1.75% on Thursday to support the economic recovery, according to a Bloomberg survey. Bank Negara Malaysia in August cut its 2021 economic growth forecast to 3%-4%. The Malaysian ringgit climbed to the highest in over two months on Monday
• Russia’s central bank may hike its policy rate for the fifth time this year, with the median forecast in a Bloomberg survey predicting a 50-basis-point increase to 7% on Friday
• Poland will likely maintain its benchmark on Wednesday at a record low of 0.1% as policy makers see inflation being driven by the reopening of the economy after the worst of the pandemic
• In Peru, policy makers will probably lift the benchmark rate by 25 basis points to 0.75% on Thursday. Forward guidance should signal additional hikes, with rising inflation expectations, capital outflows and currency depreciation, according to Bloomberg Economics