There is life in the great emerging market carry trade yet, although now it comes with a twist.
Investors are betting a trade that reaped returns of more than 20 percent last year for borrowing US dollars to buy Brazil’s real, Russia’s ruble and South Africa’s rand has further to run — only they are using the battered British pound to fund long positions in emerging market currencies.
Citigroup Inc on Monday named shorting the pound against the Russian ruble its top trade of the week.
The so-called carry trade, in which investors borrow in countries with low rates to invest in higher-yielding assets, lost some of its appeal late last year as rising US borrowing costs bolstered the greenback and US president-elect Donald Trump’s victory damped appetite for risk.
Now the pound’s volatility, sparked by the UK’s decision to pull out of the single European market, is making developing markets look like a relatively safe bet.
“Sterling is as volatile as any emerging market currency at the moment,” said Ben Kumar, an investment manager at Seven Investment Management, which oversees about £10 billion (US$12.3 billion) and is adding to holdings in emerging market local-currency bonds.
“The currency risk is much easier to take than emerging market currencies versus the dollar,” he added.
The pound’s wild swings have closely tracked every new piece of information on the British government’s Brexit plans.
The currency plunged more than 1 percent on Monday, then surged more than 3 percent on Tuesday after British Prime Minister Theresa May said British lawmakers would get a vote on the final deal for the nation’s exit from the EU.
A measure of the pound’s price swings against the dollar in the past week climbed to 23.3 percent on Tuesday, the most among 16 major developed nation and emerging market currencies.
One-month implied volatility, based on prices of options to buy or sell the pound against the dollar and seen as a gauge of trader’s expectations for future gyrations, climbed to a three-month high.
Many emerging market countries offer attractive carry trade opportunities, because they were forced to push up interest rates during the 2015 commodity crash.
Those relatively high rates, together with currency gains against the dollar, garnered carry returns of 32 percent for the ruble and 21 percent for the rand last year.
Using the pound for funds, returns in the first two weeks of this year were 4.2 percent for the ruble and 2.5 percent for the rand.
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