The invisible carry

One of the basic ideas of investing in emerging markets is that whatever it is you are going to make by holding EM assets will be boosted by the currency return. For the most part, currencies in emerging markets have beaten their respective forwards. To take a real life example, you can today sell USDZAR 1y forward at almost 9.50 expecting the spot to fix much below that in 1 year’s time. Sure, sometimes you would get hosed (particularly on the rand) but in principle it has been a winning strategy over the longer term. Just see never-ending EM bullish comments from Mark Mobius or Jim O’Neill. Happy days, at least for them…

Such a phenomenon has a strong backing in the macroeconomic theory, which tells us that countries experiencing higher growth rates should see their real effective exchange rates appreciating. Of course this will happen through a combination of nominal appreciation and higher inflation but as long as the particular USD/EM cross doesn’t go up, investors should be happy.

But carry is not only about beating the forward in the FX market. There used to be a much powerful, yet less known set of transactions aimed at generating carry. I am talking about buying short term debt issued by emerging markets and funding it in the FX swap market. This transaction used to be loved by banks – they would use their cheap USDs, convert them to an emerging currency in an FX swap and buy the debt, mostly up to 1y maturity. This had three key benefits to emerging markets:

  1. provided a steady supply of hard currencies to the economy (financing of the current account deficit),
  2. increased the demand for government debt (financing of the fiscal deficit),
  3. was pretty stable as banks could withstand a lot of volatility by keeping assets in hold-to-maturity portfolios.

If you think of it, the first two points must have significantly contributed to superior growth rates in many emerging economies, thus enabling the “beat the forward” crowd make money.

Interestingly, right after the financial crisis of 2008/2009, this activity increased. Banks suddenly got access to super cheap funding from monetary authorities and the Basel committee had not woken up yet to throw new regulations and capital/liquidity requirements. At the same time, cross-currency basis widened considerably. This meant that “some currencies are more equal than others“. Or put differently, as much as before the crisis the Mexican peso or the Polish zloty would be trading at par with the USD in the money market, having the dollars right after the most acute phase of the financial crisis passed was a huge advantage. Banks (and some hedge funds via a structure called Total Return Swap) made a lot of money on that. A LOT…

But then the access to USDs became so universal that the greenback ceased to trade at such a premium and, of course, the new regulations came making it exceptionally difficult to use banks’ balance sheets for carry trades in emerging markets. But fair enough, maybe this sort of money-making method should not really be used by banks.

There are, however, pretty wide implications. I have already hinted that the described activity of banks was one of the important reasons why EM growth (and consequently currencies) outperformed. Also recall that the funding achieved by emerging economies had been pretty stable until the changes came. So with this in mind, does it still make sense to talk about carry trades in emerging economies?

I did a quick exercise analysing how long it takes to wipe out the quarterly carry in Mexico and South Africa (I have chosen them at random). I basically looked at average daily depreciation over the course of a month and compared that to the quarterly carry. In both ZAR and MXN I got a similar result, i.e. 2.6 days. Imagine buying the rand and the peso for the carry on Monday morning because you think carry trades will perform. By the time you return from lunch on Wednesday your quarterly carry could be wiped out. Puts things in perspective, doesn’t it?

How to trade this? I know I have committed to giving some trading clues after my posts but here a better question to ask is how NOT to trade this. It may sound like a cliche but seriously, if someone tells you to buy a currency “because the carry is good”, just show them the door. Secondly, I would caution against assuming that volatility will increase as people get stopped out on carry positions in emerging markets more often. The sad truth may be that as much as many FX-focused banks would hate it, speculative activity in EMFX could remain quite low, in which case it will be economic cycles determining exchange rates. And trends are usually associated with low implied volatility…

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4 thoughts on “The invisible carry

  1. Pingback: The invisible carry | Kenneth Carnesi

  2. Carry trade is a synthetic short gamma trade, like selling naked options. Specially in EM where the risk of sharp devaluations are higher. On top of that, it is usually a crowed trade. Hence the abnormal returns of carry trade positions are the reward for bearing the disaster risk, you could lose in a day the carry of the full year.

  3. Pingback: What the central bank giveth, only the central bank taketh away | barnejek's blog

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