EM FX Carry Trade Update - March 31, 2020 - HUF in focus

Forex 8 minutes to read

John Hardy

Head of FX Strategy

Summary:  Many EM currencies have bounced slightly from recent lows, but others are under renewed pressure even after a significant recent recovery in risk appetite. We focus special attention on CEE currencies in this editions, normally something we have not done in the past as there is really no notable carry available in these currencies, but the situation demands our attention.


Since our last update in late February, the Covid19 pandemic has devastated the EM space as investors have picked up stakes and run for cover, leaving EM assets and currencies in a woeful state. Credit spreads have blown wider and EM central banks on balance continue to cut rates to support their economies rather than fretting the instability or inflation from the risk contagion or inflation. We focus on CEE currencies, especially HUF, in this report after Hungary, nominally an EU country, has granted its Prime Minister Viktor Orban the right to rule by decree indefinitely.

The Covid19 crisis continues to present risks to the EM complex and currencies and the EM policy response of continuing to cut local policy rates even as currencies come under severe strain is at odds with historic behavior. Therefore we are in favour of minimal to no exposure to carry trades at this time and will look to bargain hunt once it is clear that the Covid19 crisis is ebbing and some sense of normalcy is returning and/or if market disorder worsens materially and EM central banks begin to move more forcefully in support of their currencies.

YTD EM Carry trade performance in 2020.

Below is a snapshot from a Bloomberg tool for measuring FX carry performance, a snapshot we will release with every update this year for a sense of how carry trades have performed in broad terms. The given basket here is for the higher yielding of the (formerly fairly liquid) EM currencies against the formerly lowest yielding G10 currencies, though in the latter camp, no country features a policy rate above 0.25% now.

This basket returned nearly 15% in 2019 due to that year starting at a very low point for global risk appetite. After a strong start to 2020 on an extremely supportive backdrop in financial conditions, the basket has now given up all those gains and effectively also the gains from 2019, even adjusted for carry. Note that the benchmark – the MSCI EM equity index in USD terms – has dropped some 25% on the year after a drawdown of some 33% at its worst point.

Source: Bloomberg

Short term EM currency performance
The below shows the 1-week and 1-month carry-adjusted performance of the EM currencies in our universe and really paints a picture of the tactical bounce relative to the one-month sell-off for many EM currencies on the impact of the Covid19 crisis sending investors running for the exits. Only the Chinese renminbi and the odd Philippine peso have offered some modicum of stability.

Source: Bloomberg and Saxo Group

Chart: Saxo Bank Global Risk Indicator
The deepening of the Covid19 crisis in March saw our measure of risk breaking new ground, requiring that we recalibrate the y-axis in our global risk indicator to indicate the 5 standard deviation deterioration in conditions during the worst days of the crisis. The intensity will likely prove impossible to worsen beyond these levels for some time to come as the model adjusts for recent information via a moving average lookback window, but as long as we remain below zero on a moving average basis, the indicator continues to point to dicey conditions for risk sentiment, even if many components of the indicator have come well off their highs after huge spike that preceded increasingly heroic efforts by the Powell Fed in particular to race to get ahead of this crisis.

Source: Bloomberg and Saxo Group

EM Credit Spreads
The chart below shows six examples of developments in EM credit spreads – which are all uniformly negative after showing odd hold-outs in late February (for example MXN was late to break lower on the mistaken belief, perhaps, that the pandemic wouldn’t go global and Mexico might benefit from added investment in capacity that wasn’t coming out of China). South Africa suffered a downgrade to junk over the weekend and this has taken USDZAR to new highs as credit spreads blow particularly wider there.

Source: Bloomberg and Saxo Group

Special focus – HUF and CEE countries
We are focusing on EU existential risks during this crisis as the EU has been the recent epicenter of the crisis (likely shifting to the US and elsewhere in a matter of days) in particularly because of a very weak video-summit between EU leaders last week that brought no solidarity to the table, punting for another summit within two weeks.

But outside of the monetary union countries, we have to realize that we are already seeing strain priced in for countries that are nominally in the EU but not the EMU – all of which have seen very weak currencies on poor liquidity and risk concerns. Worst hit recently have been the CEE countries and the situation in Hungary is particularly worth noting here. This crisis in CEE has come after many years in which the CEE countries’ exchange rates were rarely affected by the ups and downs shaking other emerging markets as it was assumed that these countries were in an increasingly tight orbit with the EU, But with Hungary’s move to grant its prime minister Viktor Orban one-man rule powers indefinitely, the market is waking up to the errors of its assumptions. Ruling by strong man decree is completely at odds with EU’s principles of governance and could see the EU escalating its sanctions already in place – putting Hungary’s economy at risk if foreign capital withdraws operations and its currency at risk of a further downward spiral. Already Hungary’s currency was extremely unattractive recently as inflation has spiked above 4% year-on-year while the central bank of Hungary kept the policy rate below zero – massively negative real rates.

The chart below on the right shows USDHUF – the dark red line vs. the spread on a 2041 Hungarian sovereign USD bond. We used this bond as all other Hungarian sovereigns denominated in foreign currencies are for much shorter maturities. We did the same on the left for EURPLN and a longer dated Polish sovereign bonds, where the pressure on credit spreads is also evident. Note that HUF was actually advancing against PLN from mid-February until HUF suddenly began underperforming its larger CEE cousin over the last week – watch HUF as the EU reacts to Hungary’s political earthquake. RON and CZK are also under pressure, it should be noted.

Source: Bloomberg and Saxo Group

Carry trade performance*
The chart below shows the longer term performance of the US dollar versus the lowest yielding funding currencies. In times of sheer market panic, the USD tends to act as a safe haven – and “lowest yielding” is a less interesting statistic now that all G10 currencies have a policy rate of 0.25% or lower. Only CHF and JPY have somewhat managed to keep pace with the USD over the three-month time horizon.

Source: Bloomberg and Saxo Group

With the depths of this crisis, almost all EM currencies have turned lower versus the US dollar for all measured time frames with the CNH a notable exception on China’s interest in maintaining stability and the PHP the odd one out (perhaps a focus on its commodities import bill, particularly fuel, collapsing.

Source: Bloomberg and Saxo Group

Current carry available*
The chart below simply shows the forward carry for owning the USD versus funding currencies and the returns on higher yielding EM currencies versus the US dollar. We can only continue to look on in astonishment as so many EM central banks have continued to cut rates even as their currencies come under extraordinary pressure – usually bottom fishing in EM FX is ripe when currencies are in a tailspin and the EM central banks are rapidly hiking rates in defense mode.

Source: Bloomberg and Saxo Group

*Note that all performance calculations are done as carefully as possible to include trade spread costs and market conditions at the time but actual results will inevitably vary depending on the timing of rolling forward positions and other factors.

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