Earlier, we talked a bit (more) about EM and the extent which the rally is or, more likely, isn’t sustainable.
There are headwinds. Lots and lots of them. Some of which have been mercifully offset. For instance, a Fed that wants to normalize has been offset by a reversal of sentiment in Treasurys, where yields are no longer feeling the reflationary love and where specs are now the most long the 10Y since December 2007. That, in turn, has weighed on the dollar, providing EM with a cushion.
Meanwhile, yuan volatility has been subdued, effectively short-circuiting the FX transmission channel that might otherwise serve as the conduit through which turmoil in commodities and anomalies in China’s bond market would spread to the EM complex more generally.
But perhaps the simplest explanation is this, via Barclays:
There’s a wall out of money out there that continues to be flooding into emerging-market assets, looking for carry in a low-volatility environment.
Well, just to flesh this discussion out a bit, we thought we’d highlight some (maybe) useful commentary out Monday from BofAML. The note is about carry and as such, the title is appropriate: “The Rich Get Richer.” According to the bank’s EM carry sentiment indicator (something they just dreamed up), the EM carry trade is “approaching exuberance level.” More below…
Our new indicator of EMFX carry sentiment is approaching a level that has preceded corrections within the next 4 weeks after the indicator level was reached, based on 10- year back-testing. However, we think such a correction will likely be bought again, and the EM bubble we called for in January is likely to continue to build in the months ahead.
We introduce an EM carry sentiment indicator to help identify potential high and low inflection points in conjunction with other BofAML EM market analysis tools available to identify triggers in the market. The EM carry sentiment indicator is created by aggregating four variables intended to measure the level of bullishness by investors characterised by flows into the EM fixed income and FX market.
The indicator, as shown below in Chart 1, tracks investor sentiment on a range of 100 (most bullish) to zero (most bearish). We use the term exuberance to denote when the indicator has reached levels above 90 and anxiety when levels have reached below 10 as these levels have historically preceded sell-offs and rallies, respectively, in the Bloomberg EMFX carry index during the subsequent 4 weeks after the indicator level was reached, based on backtested indicator results over a 10 year period.
The latest reading is at the 81st percentile, which has preceded a EM carry sell-off in the next four weeks 58% of the time over the 10 year backtested period. However, we still fall short of the 90th percentile, at which our back-test has indicated a EM carry sell-off 63% of the time over the period examined.