EM FX Carry Trade Update October 22, 2019

Forex 5 minutes to read

John Hardy

Head of FX Strategy

Summary:  Global risk conditions are about as supportive for emerging market assets and currencies as they can be. As long as the Fed can stay ahead of the curve and provide the easing that the market expects and avoid any tightening of risk conditions, the complacency and support for EM assets may be justified, but we are a bit cautious.


The global market conditions can hardly get more support for emerging market assets, as the US dollar has weakened, risk sentiment is strong as global equities run higher, and credit spreads of all stripes compress. And emerging market currencies and assets have responded to the backdrop with solid rallies, nearly across the board. Still, we have a hard time believing that the sailing will remain completely smooth from here if the US is in for some kind of recessionary landing for its economy in the quarter to two quarters ahead. Sure, US economy weakness could bring powerful easing from the Fed and new balance sheet measures, all measures that would wear on the fundamental support for the US dollar.  But US recessions are normally associated with rocky conditions for equity markets, credit spreads and risk assets in general, hardly a menu of factors supportive of EM assets and currencies. Given the mismatch in expectation versus what we fear the reality might prove for the US economy and risk assets, we are a bit cautious here, while recognizing that there isn’t a jot of fear out there for the outlook for EM assets.

Chart: Saxo Bank Global Risk Indicator

Our last report came just as risk conditions were improving from a sudden dip in risk conditions and this one arrives with risk conditions about as supportive as they possibly can be for emerging market assets and currencies. Our global risk indicator rarely heads above a positive 1.00 for any length of time and we are close to that level now. From here, the next tests for emerging market-asset supporting risk sentiment will include:

  • Whatever form a US-China trade deal takes, if any. Perhaps already priced is some sort of very narrow, transactional deal with the US side climbing down from some of its tariffs while China promises to make large purchase of agricultural and other products. Huge upside surprise, but slim odds, if the deal is more comprehensive in nature, something we see as unworkable as the natural rivals are not likely to come to terms on national security and technology transfer issues.
  • How the Fed continues to position its balance sheet operations and the rate outlook at the next FOMC meeting on October 30.
  • US incoming data. Material weakness in the US economy would likely see the Fed chopping very quickly – by fifty basis points per meeting – but the Fed chopping very quickly is historically in response to severe distress in market- and financial conditions, so by itself, Fed easing does not necessarily mean that EM assets would celebrate. Historically, it also takes time for the market to feel comfortable that the Fed is getting ahead of the curve and providing sufficient easing to turn sentiment back higher as a recession plays out.
  • At the margin, whether the Bank of Japan is able to impress with any new measures it takes at its October 31 meeting after promising a policy review the last time around. The BoJ can’t really do anything in our view on the interest rate front and may only add to futile asset purchases at the margin.
Source: Bloomberg and Saxo Bank Strategy and Research

Carry Trade Short Term Performance
The shorter-term performance of EM currencies shows nearly all currencies higher versus the weak US dollar with the prominent exception of the Chilean peso (CLP), which has fallen after violent protests in recent days to cost of living increases have taken the world by surprise.

Carry trade performance*
Among the funding currencies, the JPY has been the “winner” in being the only currency to stay weak versus a very weak US dollar, while two of the other negative yielders, the EUR and SEK have staged a bit of a revival and sterling has been rising sharply on hopes for an imminent smooth Brexit.


Source: Bloomberg and Saxo Bank
Among the EM currencies, most have put in a positive 1-month performance against a rather weak US dollar, but the prior weakness in the weakest EM currencies – all in South America – over the 3-month and 6-month time frame makes the general EM up and USD down move look less impressive than it actually has been over the last month.
Source: Bloomberg and Saxo Bank

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. Note the ongoing collapse in carry available for TRY longs as China’s massive support for Turkey has countered general market concerns, especially geopolitical volatility around Turkey’s move against Syrian Kurdish forces. The policy rate in Turkey has collapsed from 24% to 16.5% at the last meeting and is expected to move quickly lower still.

Source: Bloomberg and Saxo Bank
*  Note that all performance calculations attempt to accurately reflect trade spread costs and market conditions but actual results will inevitably vary depending on the timing of rolling forward positions and other factors.
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