With the dollar stabilizing on Monday and Tuesday amid the palpable relief rally in risk assets coming off a weekend that didn’t end up being nearly as apocalyptic as feared (and that’s what it’s come to these days – “not the apocalypse” is the new “it was a good weekend”), spare a moment to consider the consequences of a dollar that manages to rebound sharply and sustainably.
“Investors have poured $19.2 billion into local-currency emerging-market debt funds this year, the fastest pace of flows since 2010, helping to drive some of the biggest returns on record,” Bloomberg mainstay and woman who is nearly as prolific as we are, Lisa Abramowicz, writes on Tuesday. “But behind the broader rally and accelerating flood of cash into these markets lies something much more simple: a weaker dollar,” Lisa continues, adding that “EMFX has gained 9.6% so far this year against the greenback.”
Consider that figure and then have a look at the total return on the Bloomberg Barclays Global EM Local Currency Government Universal index:
Get the picture? Here’s Lisa again: “this increasingly popular slice of bonds has essentially turned into a multibillion-dollar bet on the dollar.”
The problem here – of course – is that this debt isn’t very liquid and so, in the event we do get a reversal of fortunes for the beleaguered greenback (like say, if Treasury yields rise or if there’s good news on tax reform), the situation for EM could turn volatile – and “big league.”
So one hopes investors are cognizant of the possibility that they are chasing an EM FX rally more than they are “investing” in emerging markets with this trade.
Or, as Abramowicz puts it, “investors may have wandered into a casino and not even realized it.”