With a strong dollar, the ‘reverse carry trade’ strategy gains space and…

Bloomberg — For decades, investors in the stock market exchange global took loans in dollar at low interest rates and invested the resources in emerging market currencies with higher yields. But these flows are starting to turn upside down.

The restrictive monetary policy of the Federal Reserve it has been going on for so long that some emerging economies are finding it difficult to keep their currencies competitive and are becoming targets of the so-called reverse carry trade. Strategies of this type, in which the investor is sold in an emerging currency to invest in dollars, generated returns of up to 9% this year.

The Chinese yuan, the Thai baht, the Malaysian ringgit and even the Czech koruna are some of the currencies used. This does not mean that the carry trade traditional currency is dead: it is still used to invest in high-interest currencies such as Brazilian real, Mexican peso, turkish lira It is Egyptian poundbut even these bets are increasingly financed by the Japanese yen, the Swiss franc or another emerging currency like the yuan rather than the dollar.

“We like to hold the US dollar against Asian currencies,” said Paul Greer, a manager at Fidelity in London. “We like to use low-beta, low-rate Asian currencies for funding, as well as the euro and the Czech koruna, where we are pessimistic about growth prospects.”

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Investors have already pushed their forecasts for the first US interest rate cut from March to December. As a result, those who bet against the dollar to finance their exposure to emerging markets have suffered the deepest losses since 2021, holding riskier currencies that offer lower or negative returns.

The two main factors for the success or failure of the carry trade are: currency pair fluctuations and interest rate differentials. The ideal is to take a low interest rate in a currency with a tendency to depreciate — hence the popularity of the yen — and invest in one with high interest rates and a tendency to appreciate.

The dollar’s global strength has pushed 29 of the 32 most traded emerging market currencies into losses this year. At the same time, there are 11 emerging countries where interest rates are lower than in the USA.

“Now you have to pay to hold currencies in these countries, including China, Taiwan and Korea,” said Manik Narain, head of emerging market strategy at UBS. “While Asia is dominating the negative carry theme, the carry buffer is also shrinking in some of the other pockets of emerging markets.”

UBS recommends being short the yuan and long the dollar, in the expectation that the government in Beijing will allow the Chinese currency to depreciate to recover some of the competitiveness of the country’s exports, eroded by the weakness of the Japanese yen. This could depress emerging market currencies as a whole by driving more carry flows in the opposite direction – towards the dollar – Narain said.

See more at Bloomberg.com