Emerging Markets FX Insider: Carry On

Risk assets have charged out of the gates so far in 2012 – global equity markets are broadly firmer, oil prices are seeing greater than double digit percentage gains (on average), and the US Dollar has been offered across the board.

In FX, emerging market currencies have reaped the benefits of improving sentiments. A plethora of risk supportive developments can be credited for this run up in EM FX (see chart below) – Greek bailout plan #2, accommodative monetary policy directions, and improving US economic data.
FLOWS POURING INTO EMERGING MARKETS

With financial markets rallying since the start of the year, market players have poured into so called ‘risk’ currencies in search of higher yields. Emerging market equity, fixed income (FI), and hard currency funds have been the major benefactors of this with Asian and Latin American equity and FI funds leading the way higher. European fund flows, however, have not taken part and this should come as no surprise considering the region is the source of global systemic risk (see chart below).

DIVERGING ADVANCED: EMERGING MARKET CB MONETARY POLICIES

Looking forward, monetary policy outlooks for the central banks of select advanced and emerging markets appear to be on divergent paths. The Fed has already pledged exceptionally low rates until 2014 while keeping the door wide open for QE3, ECB liquidity injections seem more a necessity than a possibility, the latest BOE minutes imply additional asset purchases may be in store, and the BOJ recently increased their asset purchase program by ¥10tln to ¥65tln.

Many emerging market economies, however, are grappling with rising inflation. In Turkey, both consumer and producer prices are in the double digits, Singapore CPI rose more than expected to 4.8%, the Czech Republic saw consumer prices rise 3.5% y/y from a prior 2.4%, South Africa Jan. CPI rose to 6.3% y/y, and consumer prices in Hungary rose to 5.5% y/y in January.

CARRY ON

In addition, already increasing inflation in emerging market economies will likely be exacerbated upon implementation of further accommodation by the Fed, ECB, BOE, and BOJ. To combat rapid price increases, EM central banks would have to adopt a tightening bias or maintain a hawkish bias. As a result, the carry trade may come back in favor on the back of expectations for widening interest rate differentials.

EUR/TRY: Back on October 25th, we highlighted the potential for diverging ECB: CBRT (Central Bank of Turkey) policy directions to provide a short EUR/TRY opportunity while earning positive carry interest (Click here to view Emerging Markets FX Insider posted 25. Oct. 2011 and last updated in Emerging Markets FX Insider - Low U.S. & Euro...posted 02.07.12 ). In the most recent update, we noted the potential for a pullback and recommended remaining shorts to adjust 2.2750 limits to 450 trailing stops so as to protect profits. In the most recent CBRT rate announcement, the central bank lowered the upper end of the interest rate corridor down to 11.50% and softened its stance on inflation sending EUR/TRY higher to current levels around 2.3550. Potential trailing stops mentioned in the above link have been triggered around 2.3450, locking in +1300 in gains on top of any positive interest earned since Oct. 25th.

While carry adjusted volatility (see chart below) indicates positive roll value still exists within EM/DM currencies, we think the magnitude of the rally seen in ZAR, HUF, and TRY may be slightly overextended. Accordingly, we think pullbacks of 3-5% minimum would provide better positioning value for any potential carry trades; more specifically long EM FX (ZAR, HUF, and TRY) funded via select G10 currencies (EUR, GBP, JPY, and/or USD).