Eddie Vedder and the Japanese carry

Just like everyone else in the financial markets over the last week or so I have become the world-famous specialist on Japanese flows (!)*. I have heard a lot of more or less plausible stories and when I was trying to digest all the noise, I couldn’t help but think about “Nothing As It Seems” by Pearl Jam:

Occupations overthrown, a whisper through a megaphone
It’s nothing as it seems, the little that he needs, it’s home
The little that he sees, is nothing he concedes, it’s home
And all that he frees, a little bittersweet, it’s home
It’s nothing as it seems, the little that you see, it’s home…

Jeff Ament, Pearl Jam

I am not certain what is going to happen with the wall of money that is seemingly coming from Japan, but I know that there’s a remarkable amount of superficial analysis, which I would like to comment on.

1. The Japanese carry trade will continue as the BoJ prints more.

According to estimates by Daiwa net issuance of JGBs after stripping BoJ purchases will be -26trn yen. This is around 5% of GDP, which is a pretty monstrous amount. This naturally makes people’s imagination go into overdrive, particularly as we’re talking about the country with decent carry-trading history. But there is one problem with such an approach. Carry trade was Japan’s response to the lack of returns in the local market. Bond yields have been ridiculously low and the stock exchange was still suffering as zombie-banks kept dragging it (and the economy) lower. Now, do you think this situation has not changed even a bit? We may be agreeing or disagreeing with what the BoJ is doing but investors (particularly retail) could be excused for e.g. thinking that the Nikkei will double this year. This is particularly the case as what the BoJ seems to have orchestrated is a fantastic opportunity for the Japanese banks to cash in on their available-for-sale JGB portfolios. So answer yourself this question – is it so entirely obvious that Mrs Watanabe continues buying AUDJPY (annual yield of 3.2%), ZARJPY (annual yield 5.4%) or MXNJPY (annual yield 4%)? Granted, these and many other currencies will continue to constitute a very important part of the Japanese investment portfolio but pretending that the investment backdrop in Japan has not changed is naive in my opinion.

2. The big yen move has only just begun.

Currently various forecasters are trying to come up with the most bearish view for the yen. I have already seen 120/USD but admittedly I do not pay much attention to that stuff. But try to think who has so far made money on the yen debasement? If you don’t know then try to get a hold of the HSBC hedge fund report to see that the vast majority of macro funds have caught at least a part of this move. And because selling the yen is seemingly such a no-brainer**, not being in the trade is a big career-risk for many. In some sense, macro hedge funds cannot afford to miss another leg in the yen move (if there is one). But in the greater scheme of things this is just noise. Don’t forget that the Japanese economy has just become at least 30% cheaper. And we are talking about a bunch of historically deadly innovative companies who have managed to keep their place in the global market place against all odds.

Goldman has recently produced a study showing that the country with the most similar exports composition to Japan’s is… Germany. It is already very much visible it the underperformance of the DAX, in my opinion. Personally I prefer Mercedes over Toyota but at a 25% discount I know I would change my mind.

My thinking is as follows: if this yen depreciation and the crowding out of the Japanese banks from the JGB market is persistent then Japan has every chance to become the champion of the global trade again. And if so, why on earth would I be buying GBPJPY or AUDJPY?

Let me give you another example: If you have been selling the yen and buying the South African rand consistently in the last five years then only last week did you break even on your average spot level. Sure, you got some coupons in between but it cannot be ruled out that investors who have been buying the ZAR against the JPY will just take this as an opportunity to close the position after being bailed out by the BoJ.

3. Banks will invest abroad.

This bit I find preposterous. I have mentioned above that banks may have just been given a lifeline by the BoJ and they will be able to off-load their available for-sale portfolios at a significant profit. What they do with the cash next is anyone’s guess but banks are not really in the business of punting on currency markets with their balance sheets. Believe it or not but even when GS recommends buying EURUSD, it’s not like Goldman’s treasury shifts all its money to Europe. Banks operate in the “LIBOR+” world. They are happy to take exposure to foreign bonds but it is usually done on an asset swap basis. Below are a few bonds that I just looked up on Bloomberg and how they compare when swapped to JPY.

  • T 2 02/15/23                                     78bp
  • SAGB6.75 03/31/21 #R208       68bp
  • MBONO6.5 06/09/22                    68bp
  • POLGB 4 10/25/23                          10bp
  • TURKGB8.5 09/14/22                   36bp

As you can see those differences are not huge and definitely not big enough to make emerging markets irresistible. Additionally, there’s a perverse effect of what’s been going on in the JGB market lately. The chart below shows a crude calculation of VaR for 10y JGB futures since 2000.

JGBVaR

A chart of the yield volatility is looking even scarier, which – paradoxically – could bring the Japanese banks into a risk-reduction mode as no one can bear such wild swings of the profit and loss account. And adding Brazilian assets to the portfolio doesn’t help much.

4. Asset managers, insurance companies and pension funds will invest abroad.

Yes they will. The same way as they have in the past. Well, maybe with a bit bigger size but it’s far from being certain at the moment. If it’s the yen weakness they’re after then I suppose buying the USD will do (without adding an extra layer of volatility between the USD and some other currency). And if they don’t think the yen weakens much from here then why would they accelerate foreign buying in the first place?

This brings us to the last point I would like to make. As much as in previous years the Japanese investments abroad were driven by expectations of superior returns outside of the country, we are now talking about the expected yen weakness. In my opinion this changes the structure of investors taking advantage of the move and I believe that it will be the foreigners shorting the yen, rather than the locals. This, at least in the near term, makes it a tactical, rather than a structural trade.

So these were my views on the whole situation. I don’t have any concrete recommendations this time but I just don’t like how one-sided the discussion has become. And if I’m wrong then… well… listening to Eddie Vedder while writing this post definitely made it worth my while.

* not sure how to stress that I am being ironic, but I have noticed that subtitled movies on Sky have (!) at the end of sarcastic sentences.

** I have always thought that no-brainers are for people without brains but somehow this definition hasn’t become mainstream.

Baron Münchhausen and spreads in Europe

Hieronymus Carl Friedrich von Münchhausen is known for telling the story that he pulled himself (and the horse he was sitting on) out of the swamp by his own hair.

This reference was the first thing that came to my mind after seeing this and this post on Paul Krugman’s blog. After the whole bunch of swearwords, that is.

In the first one he argues that France has finally joined the club of ultra-sovereign countries, i.e. countries who can do whatever they please and yet get away with it because bond yields remain remarkably low. The second one uses “research” material from VoxEU entitled Panic-driven austerity in the Eurozone and its implications. There are five charts in it which I would like to discuss before circling back to Krugman’s thesis about French bonds.

Chart 1. Austerity measures and spreads in 2011.

 

degrauwe_fig1

 

In this chart the author argues that the higher the spread, the bigger the austerity that was subsequently applied. Well if it isn’t remarkable – so they’re telling us the higher the increase in credit spread in 2011, the bigger the adjustment had to be? Brilliant. But let’s say it’s an introductory statement just to warm us up.

Chart 2. Change in spreads vs. initial spreads

degrauwe_fig2

Now this is epic. The Baron Münchhausen argument. It basically says that the the higher the initial spread, the bigger the subsequent decline. A few things about that. Firstly, absent of a total collapse of the eurozone, how else should this chart look like? Secondly, using the same weight for the spread on tiny Portugal and Greece as Spain or Italy is just skewing the results. Thirdly, I don’t think that using the decline in percentage points as dependent variable is kosher because spreads can’t go negative and so 50bp for France is something completely different to 50bp for Portugal. Finally, I seriously wonder if the fit would be so bombastic if they removed Portugal and Greece – those dots at the beginning seem close to the best-fit line but I have a sneaky feeling that this is mostly because of the scale.

Chart 3. Change in debt-to-GDP ratio vs. spreads since 2012Q2

degrauwe_fig3

 

First of all, this is just plain wrong from the econometric point of view. What is this -0.6747 factor in the equation? It means that if there is no change in debt/GDP then spread will fall on average by 67bp. So 10 years of unchanged debt and spread falls by almost 700bp? No, friends, such results should be deemed “inconclusive” and there shouldn’t be any downward sloping line here. But if you want the line then have a look what it would imply if debt levels fell. Spreads would increase… Brilliant. Finally, assuming no lags or anything is just ridiculous.

Figure 4. Austerity and GDP growth 2011-2012  <– this one I actually have no problems with. Stating the obvious, but so be it.

Figure 5. Austerity and increases in debt-to-GDP ratios

degrauwe_fig5

 

This one says that austerity increases debt to GDP. A lot has been said on the subject and in the short run it is very difficult to argue with that. One could make an argument that without austerity debt/GDP would’ve increased even more because of super-high borrowing costs but let’s not go there here.

Wait a second though. So if austerity increases debt to GDP and we “know” from (ridiculous) Chart 3 that higher debt to GDP is associated with a decline in credit spread then isn’t austerity leading to lower spreads? Alternatively, if we interpret Chart 3 as the lack of relationship then shouldn’t we also conclude that austerity has no impact on credit spreads?

If the author’s only intention was to show that the ECB was instrumental in narrowing the spreads then fair enough. But the analysis provided is weak to say the least.

And this brings us back to Paul Krugman. Because if he believes in what De Grauwe wrote, i.e. that the reduction in spreads was the function of how high the spreads went in the first place then why has France rallied so much? Similarly, why would it rally if austerity worsens things so much?

Oh, I know why. Blame the markets (both ways).

First De Grauwe:

Since the start of the debt crisis financial markets have provided wrong signals; led by fear and panic, they pushed the spreads to artificially high levels and forced cash-strapped nations into intense austerity that produced great suffering.

Then Krugman:

Markets have concluded that the ECB will not, cannot, let France run out of money; without France there is no euro left. So for France the ECB is unambiguously willing to play a proper lender of last resort function, providing

If one wants to make an argument that OMT has led to significant tightening of credit spreads in the eurozone, we really don’t need working papers – a tweet will do. But for crying out loud do not mix austerity with that. Especially as austerity and OMT were completely coincidental. And if you do have to mix austerity into all this then make a little bit of effort to make a consistent and mathematically correct set of arguments. And make up your mind, Mr. Krugman. Either austerity is bad and ultimately keeps debt to GDP high and thus credit risk elevated in which case you need to rethink France. Or austerity sometimes makes sense in which case… well… you need to rethink a hell of a lot of things.

Otherwise your story is not far from what Baron Münchhausen – amusing and entertaining but ultimately ridiculous.

 

Systemic ain’t what it used to be

I remember that in the first days after the bankruptcy of Lehman Brothers, many believed that the collateral damage would not be terrible. I distinctly recall asset managers who were still eager to discuss idiosyncratic factors in some emerging markets. Not that I was so much smarter back then – after all, I did not send an email entitled “SELL EVERYTHING”. Of course shortly afterwards came an avalanche and dominoes started falling. All of a sudden everything appeared systemic, even things you wouldn’t normally care about.

Just to give you a few examples from my turf:

  • Iceland was relevant because of huge assets of local banks outside of the country (aka Icesaave);
  • Hungary (and CEE in general) was key for survival of Austrian and Italian banks;
  • Latvia threatened the stability of the banking system in Sweden;
  • Ukraine was a big risk for French banks;
  • The Middle East… well, it’s always considered to be a tail risk anyway.

One could extend this list quite a bit.

Considering the fragility of the financial system back then, any of those factors could’ve spiralled out of control. Therefore we had various programmes, such as the Vienna Initiative which were aimed at ring fencing potential fallout. When that initial phase of panic ended (with the London Summit) we had a brief period of calmness followed by the mighty Eurocrisis.

This one has been very similar to the initial “Lehman” stage. First came Greece, which initially was considered to be not that relevant. That was the case until roundabout the PSI Summit of 2011, which – perhaps inadvertently – wreaked havoc in the system. There was also Ireland with its “bad bank” ideas and the Iberia with all sorts of problems. And then, again, everything became systemic and potentially fatal. The culmination of it all was in my opinion when a) the market went after Italy and b) people wanted the Bund to start trading with a credit premium (search Bloomberg headlines towards the end of 2011 if you want to see that actually was the case).

Like with the Lehman, many people missed the Eurocrisis trade and began making up for that by creating more or less far-fetched implications. I described this mechanism in one of my previous posts about Slovenia. But does anyone really care about Greece or Ireland anymore? I know there’s punting going through in GGBs and some when-in-trouble-double funds made a killing buying Irish bonds but in terms of global significance this is barely relevant. Similarly, we shouldn’t really care about Cyprus, although some people are trying to persuade us it’s yet another reason to buy gold bitcoins and hide.

In this vein, I was actually pretty impressed with recent comments from Jeroen Dijsselbloem. He is right and he knows he can take a bit of a gamble by speaking his mind: not everything is systemic. And if something is then, well, we have the Draghi Doctrine.

Granted, Europe is pretty screwed economically and this won’t change anytime soon but this is a completely different set of issues than forecasting the total annihilation of the financial system. The two most important measures of stress, i.e. the cross-currency basis between EUR and USD as well as the BOR-OIS spread are telling us that we should change the way of looking at European affairs. And maybe this is the answer to a tweet from Joe Weisenthal asking why on Earth is the euro so stable. The euro has plenty of reasons to fall and I have been suggesting short EUR/EM positions lately but systemic just ain’t what it used to be.

The truth about € in Poland, Mr. Krugman

As a big fan of IS/LM, I have always admired Paul Krugman. He obviously knows his stuff but more importantly he has held his stance throughout the crisis and has done it in a very convincing way. This will definitely be remembered.
However, I sometimes have issues with what he says and these issues are proportional to the distance between him and the subject in question. While his views on Iceland were pretty much in line with what I think, I’ve been under the impression that he oversimplified things by conveniently ignoring the fact that there is a lot of cash trapped there, which will remain a big problem for many years to come. But this is nothing compared to what in my view is a completely misguided and superficial analysis of the Baltics. The fundamental difference between what he says and what I think is that for me just because a country that used to run significant excesses before the crisis has not returned to the previous level of output is by no means a proof of a failure of local policies. I would argue that a lot of pre-crisis GDP was, in effect, phantom and should not be treated as a benchmark. Additionally, countries like Lithuania are an example that internal devaluation can work well, which you can see looking at a rapid growth in productivity in recent years. And no, I don’t care that a lot of that has happened through reductions in employment. Not because I’m a heartless liberal but because a lot of the pre-crisis employment should not have happened in the first place. The same situation could be observed in Latvia and yet prof. Krugman keeps waving the GDP chart saying how ridiculous the policies have been.
But I wasn’t going to write about the Baltics. Today I read Paul Krugman’s latest post entitled Poland Is Not Yet Lost. The mention of Latvia aside, there is nothing in this post that would be factually incorrect – Poland did have a “nice” global recession and the zloty was an efficient corrective mechanism in 2009 and after.
However, the problem with his post is that it discusses an absolutely irrelevant issue of Poland joining the EMU. Sure, the Polish authorities have been quite vocal mentioning that in recent months but in my strong opinion it has nothing to do with the actual intention.
What’s the reason then? Polish bonds. After a spectacular rally in 2012, yields on POLGBs reached record low levels and the curve flattened dramatically as the NBP stayed way behind the curve. At the same time, standard valuation metrices like eg asset swaps or carry have become extremely tight. To the point that without assuming a paradigm shift or without classifying Poland as a safe haven it was difficult to justify further strong purchases. “Expensive” was the word most commonly used at the turn of the year. The Finance Ministry, which by the way holds a Ph.D. in public relations, realised that too and was frantically looking for a way to portray POLGBs as “still attractive”. And they quickly found one, ie the spread to Bund, which is hovering above 200bp. But in order for people to start looking at this spread they had to give them a reason. Joining the EMU was one. And believe me, this has been quite successful judging by how many requests I get about this spread these days.
Talk is cheap and Poland knows about it so if saying that eventually the zloty will be converted into € can bring us some flows then why not? Especially that there hasn’t been any commitment regarding the date or no indication on how on Earth Poland will meet the Maastricht criteria. But I guess this is a much simpler strategy of communication than trying to explain how the budget will cope with the first drop in consumption in almost 20 years or what does it mean that the budget deficit is already at 60% of the full-year plan after only two months. I guess it’s good there’s Hungary (and now Slovenia) next door who will always attract eager sellers, eh?
But coming back to prof. Krugman, I realise that my credentials are nowhere near his. Heck, I’m not even writing this under my own name. Still, I think in cases like Latvia or Poland, he lets his ideology run before the analysis of what actually is going on.

But you start to follow the money…

Attention, there are three words generally considered to be offensive used in the following post.

You follow drugs, you get drug addicts and drug dealers. But you start to follow the money, and you don’t know where the fuck it’s gonna take you

– Det. Lester Freamon

This is a pretty famous quote from The Wire that’s been echoing in my head since last weekend, i.e. after the Cyprus crisis grabbed all the headlines. But unfortunately, unlike in the case of Detective Freamon, it wasn’t because I admired the meticulous and hard work people have been putting into trying to figure out the broad consequences.

Sure, the blogosphere’s reaction last weekend was marvelous and in my opinion helped to stabilise markets this week, but alas it’s not really an event in the eurozone if you can’t draw some explosive (and most of the time daft) parallels. Before we get to those I’d like to say a few words about origins of such a situation.

Haircut of depositors in Cyprus took the market by surprise. And by market I mean investors and traders but also the caste of research professionals whose job is to… well… try and forecast such events. Obviously, there is nothing wrong with being caught off guard from time to time and it’s the reaction to such a surprise that matters. The natural instinct of people who had not predicted what happened in Cyprus is to play it down and suggest to fade any adverse market reaction. The twisted logic here is “had it really been so important, I would’ve surely seen it coming and since I didn’t then it must be unimportant“. I’m sure there’s a name for such a behaviour in psychology but I can’t be bothered to search. In my opinion, this is the most common reaction.

If this first – let’s call it – line of defense fails and the person in question finally acknowledges that the surprising event could turn out to be quite important then another mechanism kicks in: they try and look for potential spillovers. The thinking is more or less that “ok, I may have dropped the ball here but have a look at those cascade effects that the market is missing“. I have been quite appalled to see that happening throughout the most of this week.

It usually starts with some pretty straightforward conclusions. In the case of Cyprus, people began assuming that we will inevitably have a run on the island’s banks and that it could lead to similar developments in Portugal, Spain, Italy or even Ireland. Right, because that’s what the Irish people do…

The next step in this “following the money” process was to figure out whose deposits will be cut in Cyprus. The answer to that seems to be “Russian” (although I would caution against making such a generalisation). This would look something like this…

You guys, let’s try and see how this affects Russia. Oh, here’s one: VTB is one of the most important Russian banks and it also has a subsidiary in Cyprus. Sell, Mortimer, sell! What? VTB bonds have sold off? Well then why don’t we sell bonds issued by VEB. It’s a big state-owned bank and while it has really nothing to do with Cyprus, there’s only a one letter difference to VTB so it’ll do. Oh, and did I just say it’s state owned? Mate, where’s your bid in 50m Russia30s?

Let’s move on. Cyprus is a small, country with problems in the banking system. Those problems partly stem from the immense inflow of dirty money in the past. After the Cypriot financial system reopens whatever is left of it will inevitably flee. What if it goes to Latvia, which is already a popular short-break destination for the Russians and which will soon enter the eurozone itself? (…unfortunately the person explaining to me what would happen next lost me completely and so I can’t follow this particular money trail to the end). By the way, the Latvian authorities had to start swearing that they wouldn’t end up like Cyprus. There’s no smoke without fire, anyone?

And finally, my very recent favourite…

There must be a small country in the eurozone, which has some problems with its banks and which we could sell. Hang on, what’s this little thing east of Italy that no one really knows about but occasionally makes some noises in the media? Slovenia! OMG, this is so exciting! Banks in Slovenia have NPLs reaching 20%? Some of them did not meet the ECB stress tests? The government recently collapsed and there’s a risk of an early election? I guess we’ve found a retirement trade. And don’t bother me with details that assets of the Slovenian banking system are only around 135% to GDP or that the total government financing needs for this year are projected by the IMF at 7.7% of GDP (slightly below Germany, Austria or Finland). Who cares that if the IMF’s forecasts are to be believed then Slovenia will meet both fiscal Maastricht criteria next year as it still has debt to GDP below 60%. And also, I’ve never believed in this cyclically-adjusted primary surplus mumbo jumbo…

Right, and when you’re done selling Slovenia, maybe we should look into Slovakia – there’s gotta be some connection!

I have started with a quote by Lester Freamon and I will end with one. Fifth series, episode three (entitled “Not for attribution”):

Shit like this actually goes through your fucking brain?

Dude, where’s my potential?

Last week was pretty eventful in terms of central banking. Obviously, the folk from the ECB grabbed a lot of headlines with their relative optimism but they are not the only ones trying to “whisper the reality”.

Meanwhile, two important emerging markets central banks decided to cut rates last week. And dramatically so. First, the National Bank of Poland decided to reconcile the market split between a 25bp cut and a no-change decision by… slashing rates by 50bp*. Two days later, the Banxico decided to do a similar thing, also exceeding the market expectations. Now how is that possible? Two central banks, which historically have been quite hawkish and have kept rates generally high have suddenly decided to get adventurous?

Let’s start with the NBP. Today the central bank revealed the details of its latest macroeconomic projections (a neat presentation can be accessed here). I found this chart quite interesting:

pl_potential

It shows two things. Firstly, according to the NBP models, potential growth rate has declined to below 3% from close to 6% before the crisis. Secondly, the lost output is so huge that the central bank expects the output gap to remain wide open at least until the end of 2015. In theory, that means at least two more years of zero underlying inflation pressures (caveat: see the Intermission section that follows). This is bold.

Intermission: Here I need to remind you of a significant distinction between potential output and potential growth rate. Have a look at the chart again – expected growth will exceed potential growth rate already at the beginning of 2015 (which by the way is pretty far off!). Only since then will the negative green bars start becoming smaller, reflecting the catching up with the lost potential. I don’t have a definitive answer to that but it is not entirely obvious that underlying inflation can start going up with green bars in the negative territory.

Now let’s move to Banxico. In the statement following the last meeting the central bank enumerated “structural advances” which have been made in recent years (translation here). They include:

  1. the reduction in the level, volatility and inflation persistence (ok, ok, that’s just an “idem per idem” argument)
  2. the fact that the various episodes of price adjustments have not resulted in second round effects
  3. the anchoring of expectations inflation, and
  4. the significant decline in inflation risk premium.

Of course Banxico is trying to make a big success out of it by saying that it has fostered an environment with less economic uncertainty. And good for them but someone cynical could say that this simply means that the economy has lost a significant part of its potential growth rate. I am not questioning the decision itself – I actually think the Mexicans did the right thing – but wider ramifications of it could eventually lead to even lower rates than now. Same as in Poland.

As I was thinking of the whole concept of potential growth rates in emerging economies I came across this very good article from Valor via Brazilian Bubble: Brazil’s Central Bank is in search of lost credibility. I don’t necessarily agree with everything that’s been said there but have a look at this paragraph:
Now, Brazil is not in a crisis, despite the fact that GDP has been showing subpar growth over the last two years and is on its way to perhaps the third year of such a situation. Despite that, everything indicates that the Copom is preparing to raise the Selic rate, repeating the standard reaction of a past that everybody thought had been left behind.
I can see where the Copom is coming from. Inflation remains of paramount importance in Brazil, to the point that they publish data to second decimals, as if it had any macroeconomic implications. I am not sure whether hiking rates will be the correct decision but I wanted to point out what can happen to an emerging economy if potential growth rates decline. If the economy has been showing “subpar growth over the last two years” and inflation is surging then maybe it wasn’t “subpar growth” after all?
There are of course positive examples, too. Turkey is one of them (although not very recently). I have not been in agreement with their recent policies and I think they’re throwing their undisputed success in fighting inflation to the wind but if we go a bit further back, we will see at least two episodes of a durable decline in the inflation rate. Both occurred after periods of significant economic hardship – first at the beginning of the millennium and then after the 2006 crisis. Now, Turkey had a grand opportunity to durably lower inflation after the 2008/09 global crisis but the central bank instead decided to focus on micromanaging pretty much every element of the economy. The reason I mention that is all three episodes of a shock to let’s call it “normal” level of inflation were used by the central bank to slash rates dramatically. In this respect, the CBRT recognised that the economy has become less inflationary. However, it remains to be seen whether its most recent response to global events is correct. In other words, the risk the CBRT is running is that it assumes that potential growth rates is higher than it actually is. It worked in the first two instances but that may be because they were driven by local developments (rather than the global crisis like in 2008/09). If the CBRT is not lucky this time, events could necessitate a similar approach to the Copom.
How to trade this? There seem to have been two approaches to monetary policies in recent years in emerging markets. On the one hand, we have seen activist central banks such as BCB or CBRT which have actively engaged in currency wars etc. They seem to be operating under the assumption that they need to counter whatever it is that Fed/ECB/BoJ conjure. I would call that “externally driven monetary policy”. On the other side of the spectrum you have the likes of Poland or Mexico, which – while acknowledging the impact of external developments – have maintained their reaction functions roughly unchanged. The latter group is beginning to realise that their economies are developing considerably slower than they could and so chances are that last week’s rate decisions are not the last surprises they have for us. As such money market curves should steepen there. The former group is to some extent the opposite. They are either like Brazil coming to the conclusion that inflation is becoming an issue despite slow growth. Or, like Turkey, they keep playing with fire pretending that the economy is still not strong enough to push inflation higher. One should be very careful being long duration in those, in my opinion.

* Despite huge temptation, I will not dwell on how ridiculous the communications policy of the Poles is. After two months of becoming increasingly more hawkish and suggesting a pause, they decided to cut more than expected to show that they’re done. I did not lose money on that so it’s not my grief speaking but I really believe this is the worst Monetary Policy Council among the mainstream emerging countries.

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…