The return of the carry trade?

OK, that is probably stretching it a bit, but it looks like the carry trade has returned to us for a while in the Emerging Market government bond markets. But the question is for how long.

As I have already mentioned in the first blog post, the Emerging Market countries that suffered the most in 2013 were the “fragile five”. The five countries – Turkey, Brazil, India, South Africa and Indonesia – were running large current account deficits and when investors pulled money out of Emerging Market last year, the fragile five were hit the hardest.

So, when a lot of Emerging Market funds were experiencing outflow, portfolio managers were faced with a choice: From which countries do they pull out of?

Well, if a country is running a large current account deficit the country is out of balance since import is much higher than export, putting a natural pressure on the currency. In addition, if the central bank - in this given country - is running low on reserves that can be used to defend the currency (central banks in Emerging Markets tend to hold short term foreign bonds) the currency will eventually depreciate.

Going back to the choice faced by our portfolio manager – which country does he choose to pull out of? So, if a country has a currency that is expected to devalue you might as well pull out of that country now. By the way, the dynamic behind this is much like what happens in a bank run. Depositors are afraid that their bank is undercapitalized and choose to withdraw their deposits. In order to be sure to get their deposit, the rational choice for the bank´s customers is to queue right now.  

Above you see what the returns back in 2013 looked like for an investor in Emerging Market local government bond markets. It does not look pretty, and in particular the fragile five took a hard hit. On the horizontal axis you have the current account deficit and on the vertical axis the bond return for all of 2013.

Now, if you plot the very same countries in a similar graph, from the beginning of February 2014 to today, you have something that looks like the beginning of a trend reversal.

Above you see the local currency bond returns from February 2014 to today.

All of the fragile five countries have now increased the policy rate to slow economic growth and thereby force imports down so as to improve the current account. So, the current account problem is now less severe than it was back in 2013. The currency depreciation has also made goods produced less expensive when exported. This also helps and we are on the right track again. The market recognizes this and investors are rewarded – as you can see above. I am not saying that the current account problem has disappeared - it is still there but on a less severe scale. In addition to what has been done, you also need structural reforms to do something serious about the issue. Those reforms are less likely to happen this year, as there are major elections this year in most of the countries with current account problems.

But for now, the carry trade is back. A carry trade is essentially when investors put their money in Emerging Market countries with high interest rates and funding this investment in countries with low interest rates, typically in the developed world.

So, what is missing from this picture?

Well, the issue here is when Yellen will raise short term rates in the US. It seems that what triggered the selloff back in 2013 - tapering - is not really affecting market sentiment any longer. The big question is when the FED will raise short term rates in response to improved labor market conditions. Unemployment in the US is on its way down, so this will put pressure on the FED to increase the policy rate. But, as the unemployment figure is dropping, the participation rate on the labor market is - at the same time - also falling. So, more and more people in the US are simply not looking for a job. The participation rate back in 2000 was around 67% and has since dropped to around 63%. This is a puzzle – if you want to read more about this issue, read this recent article in the Wall StreetJournal. One explanation is that the Obama administration has implemented several policy measures that simply do not incentivize people to work – an example of this is the Affordable Care Act. But, there are several factors at play here and it is not easy to understand what exactly is causing this development.  

The bottom line is: The supply of labor is not entirely understood and this means that more people can potentially return to the labor market - at some stage in the future. This can drive up the unemployment figure.  This effect will possibly delay the FED´s decision to hike rates and prolong the life of the carry trade.

So, it seems that the carry trade is back for a while. The one thing to keep in mind is when the FED will hike rates, as this will increase rates in the developed world and make the carry trade less attractive.