Reverse Carry Trade Boosts Dollar, EM Currencies Dip

Key Takeaway

• Reverse carry trade, borrowing in EM currencies to buy dollars, yields up to 9% returns amid Fed's tight monetary policy.
• Traditional carry trades suffer, with the dollar outperforming 29 of 32 major EM currencies due to robust US economy and interest rate dynamics.
• UBS recommends shorting the yuan against the dollar, predicting further depreciation and continued dominance of the dollar in carry flows.

Reverse Carry Trade Dynamics

The traditional carry trade strategy, where investors borrow in low-interest currencies like the US dollar to invest in higher-yielding emerging market (EM) currencies, is witnessing a significant shift. The Federal Reserve's prolonged tight monetary policy has led to a scenario where some emerging economies struggle to maintain competitive yields, giving rise to a reverse carry trade. This new trend involves borrowing in higher-yielding EM currencies to invest in the US dollar, yielding returns up to 9% this year. Currencies such as the Chinese yuan, Thai baht, Malaysian ringgit, and Czech koruna are being targeted for these trades. Despite this shift, the traditional carry trade persists with currencies like the Mexican peso, Turkish lira, and Egyptian pound, albeit funded by other EM currencies or low-yielding alternatives like the Japanese yen and Swiss franc.

EM Currencies Under Pressure

The resilience of the US dollar, bolstered by a robust US economy and a tighter-for-longer monetary stance, has led to losses for 29 of the 32 most widely traded EM currencies this year. The dollar's strength, coupled with the fact that benchmark borrowing costs in at least 11 frontier and emerging nations are below US policy rates, has resulted in negative relative bond yields for these countries. This scenario has made the traditional dollar-funded carry trade less attractive, marking the deepest losses since 2021 for investors in this space. UBS Group AG's head of EM strategy, Manik Narain, highlights the dominance of Asia in the negative-carry theme and suggests shorting the yuan against the dollar, anticipating further depreciation to regain export competitiveness.

Dollar's Appeal in Carry Trades

The shift towards the reverse carry trade is not limited to speculators; exporters are increasingly favoring the dollar for its higher yield. According to Simon Harvey, head of FX analysis at Monex Europe Ltd., clients are opting to park their revenues in dollar deposits, avoiding conversion back to their home currencies. This trend underscores the dollar's growing appeal as a safer, higher-yielding investment compared to traditional EM currency receivers like the Mexican peso and Brazilian real. The outlook for carry and currency moves remains divided among money managers, with some like Citigroup Inc. and JPMorgan Chase & Co. seeing potential for a rebound in riskier currencies, while others like UBS advise caution, expecting EM currencies to lag behind the dollar.

Street Views

• Paul Greer, Fidelity International (Bullish on the US dollar against Asian currencies):

  "We like owning the US dollar against Asian currencies. We like using low beta, low-yielding Asian currencies as funders, as well as the euro and Czech koruna where we are similarly pessimistic on the growth outlook."

• Manik Narain, UBS Group AG (Bearish on EM currencies including China, Taiwan, and Korea):

  "Now you have to pay to own currencies in these countries including China, Taiwan and Korea... While Asia is dominating the negative-carry theme, the carry buffer is slipping in some other pockets of EM too." "UBS is recommending shorting the yuan against the dollar as Narain expects Beijing to allow the currency to depreciate to gain back some of the country’s export competitiveness."