Market Insight: Carry trades on thin ice after Icelandic melt

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The global carry trade – the practice of borrowing in low-yielding developed market countries and snapping up more lucrative assets, generally in emerging markets – has been a no brainer in recent years.

Emerging market bonds, as measured by JPMorgan’s EMBI+ composite index, have returned 102 per cent since July 2002. The MSCI Emerging Markets stock index has surged 192 per cent since March 2003 and emerging market currencies have outperformed G10 currencies by 11 per cent over the past year – a return comprising the actual movement in the currencies plus gains on yield differentials.

But the events of the past week have, finally, raised a few doubts as to how long this happy state of affairs can continue.

First, a sell-off in Icelandic assets on purely country-specific factors led to a wobble in high-yielding and emerging market currencies. Although calm has since returned, the incident nevertheless reminded investors that trouble in one emerging market can easily spiral into a generalised sell-off, in a grim reminder of the 1997 Asian crisis.

Second, BNP Paribas said this week that its FX Strategy Carry Indicator, a gauge of the attractiveness of carry trades, has turned negative for the first time since July 2002 (excepting a one-off blip in January 2005).

The prime concern for hedge funds and other carry trade investors is that as interest rates rise in the US, the eurozone and Sweden, the cost of funding a trade also rises.

Funding costs have even started to rise in Japan, despite the fact that few analysts expect Tokyo’s zero interest rate policy to be scrapped any time soon. The yen has already made gains in expectation of a change in policy, putting further pressure on yen-funded carry trades.

“Even the threat of an appreciation in the yen may be sufficient to prompt the unwinding of carry trades, as no one will want to be the last to get out,” says Julian Jessop, economist at Capital Economics: “Replace Iceland with Japan and the implications are potentially much greater.”

Tony Dolphin, director of economics and strategy at Henderson Global Investors, is already advising his fund managers to trim their exposure to higher risk assets following the Iceland incident and a similar sell-off in the New Zealand dollar. “We have sold New Zealand dollars in some funds and we are looking to reduce our weighting in other riskier assets,” he says: “It is not wholesale switching but we are reducing our weighting of emerging market debt and trimming emerging market equities,” he says. “I suspect others are doing the same.”

Like Paribas, Mr Dolphin believes the carry trade phenomenon may be moving from an indiscriminate stage, when almost any trade involving a yield pick-up would do, to a more discriminating phase. “If Japan, Europe and the US all raise rates simultaneously, it will have a psychological effect,” he says.

However, many observers remain relaxed about the future of the carry trade. In particular, they note that although monetary policy is becoming tighter in major funding markets, broad money supply is still expanding at a rapid rate, about 7.6 per cent in the eurozone and 8.1 per cent in the US, providing plenty of liquidity.

“Interest rates may tell you the price of money, but money supply dictates the quantity of money, and monetary aggregates are growing very fast,” says Marc Chandler, head of global currency research at Brown Brothers Harriman.

“The price of money still remains pretty low and I’m hesitant to say this is the end of the emerging market rally,” says Mr Chandler, who takes comfort in the improving fiscal and external balances of many emerging market nations.

Jens Nordvig, currency strategist at Goldman Sachs, points to this improved macro management, alongside the fact that emerging market currencies are “cheap” as reasons why such currencies will continue to outperform.

Tony Norfield, global head of FX strategy at ABN Amro, remains relaxed for now.

However, he warns that the situation could change if China reduces its money supply growth, currently running at 19.2 per cent, thereby reducing the cash it has to invest in foreign assets, draining global liquidity. “If the Chinese money machine starts to slow down, that will be more of a problem for the global carry trade community,” he says.

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