Time and again, we’ve warned that EM resiliency in the face of myriad headwinds (or at least “things that should be headwinds”) is likely unsustainable.
The durability of EM flows is almost entirely attributable to the market’s faith in central banks.
Vol will remain suppressed and DM policy normalization will proceed at a snail’s pace.
If those two assumptions are borne out, then the carry trade will continue to be not just viable, but in fact a no-brainer.
EM FX vol is in a downtrend and as SocGen notes, “in most currencies, volatility is close to the middle of the five-year range, suggesting plenty of scope for volatility to decline further.”
Still, this whole thing is starting to feel a bit “picking-pennies-in-front-of- a-steamroller”-ish. But clearly, investors don’t care, as risk reversals continue to compress:
You may not think this trade is likely to be derailed by the dollar (the greenback is having a hard time getting off the mat and it seems unlikely that it’ll get a boost from the upcoming Fed meeting given that a hike is fully priced), and you may believe that as long as central banks are still in the game, any market tremors from “isolated” events like the political turmoil in Brazil and the tension on the Korean peninsula will be fleeting, but there’s one 800-pound gorilla (err… dragon) that Yellen, Draghi, and Kuroda can’t corral: China.
Here, condensed, is SocGen’s warning to anyone who is thoroughly convinced that the carry trade is bullet proof..
China is a source of angst for global investors with non-financial corporate debt at 166% of GDP compared with 97% a decade ago (Chart 8). The bursting of a debt bubble in China would have far-reaching negative implications for emerging markets either via the risk sentiment channel or through commodity prices, global growth, and the global supply chain.
History tells us that credit booms lead to bubbles and to eventual crises. In China’s case, the risks are compounded by the large size of the banking system relative to GDP (Chart 9). It is unclear if, or when, the bubble will burst in China, but it is the major medium-term risk factor for the entire EM currency complex.