So one of the interesting things to note about the price action we’ve seen over the past 24 hours or so, is the reversal of EM FX gains.
As you’re no doubt aware, there’s considerable debate about whether inflows to EM are sustainable and, relatedly, whether the YTD rally in EM assets can continue in the face of DM central banks that look like they really – really – want to try and normalize even if they have to reverse course later on.
In short: can the carry party continue or will a combination of DM hawkishness, geopolitical turmoil, and EM black swans (think: Brazil’s latest corruption scandal) eventually force an unwind?
At the heart of the EM rally is the demise of the dollar, which has been sitting at or near post-election lows for weeks on lackluster incoming data, jitters about the Trump-Russia probe, and related questions about the viability of the administration’s agenda.
So with that in mind, note the roundtrip action in the MSCI EM FX index. There’s nothing particularly surprising about this, but it does underscore the extent to which the carry trade hangs on expectations for the Fed. Observe the sharp rally after CPI and retail sales missed on Wednesday morning and the complete turnaround starting with the Yellen presser and continuing into Thursday:
With that as the backdrop, consider the following commentary from Bloomberg’s Kyoungwha Kim, who thinks the dollar demise and therefore the EM carry trade will likely persist.
- The Bloomberg Dollar Spot Index has declined more than 6% this year, after rallying more than 25% in the previous 30 months, even as the Federal Reserve ignores soft growth and inflation readings to continue with rate increases
- Even greater monetary policy support for the dollar is unlikely unless President Trump’s administration can implement fiscal stimulus to boost the economy
- And without such a boost, capital will continue to leave the country in pursuit of more attractive returns abroad
- Emerging markets attracted the biggest share of flows into equities this year, taking in $29.4 billion, according to EPFR data. High-yielding bonds in the developing nations also remain the darlings of foreign investors, leading to a continued yield compression that’s made carry traders very happy
- The potential repeal of the Volcker rule, which restricts U.S. banks from making speculative market bets with their own capital, would increase outflows from the U.S. in pursuit of yields and returns
- Until this year, developed markets consistently outperformed emerging markets since the 2008 financial crisis. Given EM economies have continued to grow as a share of the global economy, EM assets arguably have a lot of upside to make up for lost time now that they are back in fashion
- Borrowing dollars that are depreciating in value and investing the proceeds in EM is only likely to get more popular