Emerging market currencies show short-term cracks

NEW YORK (Reuters) - Emerging market currencies have been all the rage the past year given their robust economies, but it seems these assets have become less appealing to some investors at least in the short term.

After out-sized gains in 2009, these currencies, including the Brazilian real, the Chilean peso, and others in Asia, have slipped against the U.S. dollar in 2010, and strategists say these assets are showing some vulnerability as their yields have started to fall.

Most fund managers, though, are still gung-ho on EM currencies in the medium to long term, but some say it has become harder to extract gains in the short term for these normally buoyant units.

Many investors made a fortune using carry trades -- borrowing in a low-interest currency like the dollar and lending in a high-interest one such as the real, and pocketing the rate difference. But these trades no longer seem to be sure-fire money-makers.

"Risk-adjusted carry in emerging markets by historical standards is not attractive at the moment," said Ron Leven, executive director for currency research at Morgan Stanley in New York. "And it's due to a combination of the compression of rates and rising currency volatility."

Leven cited the case of the Brazilian real, which has a risk-adjusted carry of 45 percent, based on Morgan Stanley estimates, which means its carry rates had been better than current levels 55 percent of the time the last five years.

"Historically, 45 percent is just average -- not terrible, but not great," Leven said.

Brazil's capital controls, instituted in October last year to slow the real's appreciation, have pressured the currency's rate in the forward market, analysts said, reducing its carry yield against, say, the U.S. dollar and euro.

The Brazilian real has struggled against the dollar this year, falling nearly 3 percent, after rising 33 percent versus the U.S. dollar in 2009. Yet it remains the darling of the currency world.

EM NO LONGER CHEAP

"Certainly emerging market currencies in the short term are not as attractive as they were when they got crushed during the Lehman collapse. Brazil, for one, isn't particularly cheap at the current level," said David Gerstenhaber, president of New York-based macro hedge fund Argonaut Capital Management.

Gerstenhaber manages assets totaling $900 million.

Mike Moran, senior emerging market strategist at Standard Chartered in New York, thinks much of the cyclical rally in emerging market currencies is finished, which should make 2010 a tougher year.

"It's going to be less directional. We're going to see increased volatility," Moran said.

Carry trades thrive in an environment of low volatility, a period when there is diminished risk aversion and the global economy is in the midst of an expansion.

Analysts also say given the global downturn, some countries have engaged in currency intervention and that complicates investing in emerging markets.

This is part of what makes Brazil a little less alluring despite strong economic fundamentals, analysts said. Its central bank intervenes to stem currency gains, a move aimed at preserving its export competitiveness.

Intervention is also a threat in Mexico, Southeast Asia, and specifically China. Beijing has kept its currency artificially weak against the dollar, prompting U.S. legislators to threaten tariff sanctions if China doesn't revalue the yuan.

MOST EM PORTFOLIOS UNHEDGED

Despite these challenges, most emerging market portfolios remained largely unhedged, suggesting a belief that growth will remain strong in the region.

"There's certainly a positive correlation between equities and currencies," said Gavin Francis, head of client management at Pareto Investment Management in London. Pareto is one of the world's largest FX managers, with assets totaling $45 billion.

"You certainly remove that correlation and you're giving up the gain when you hedge. This whole question of hedging comes down to whether the return is paying you enough for the extra fear that you face in the long term," he added.

Standard Chartered's Moran believes it's impractical to be completely exposed to the vagaries of emerging market investing. "My sense is that 2010 is still a tremendous unknown in terms of policy and the global economy and putting no hedges on your EM portfolios is a punchy move."

Overall, the outlook for emerging markets remains strong and hedge funds have kept their faith in their currencies.

The prospect for growth is a lot stronger in some of these countries, said Aston Chan, portfolio manager at GLC, a London-based macro hedge fund with assets under management of about $2 billion.

In that instance, high growth may once again increase the yield advantage of these markets. "The rate-hiking cycle in Brazil and Mexico is going to be much earlier than in G10 countries, except Australia, and this is going increase these currencies' carry advantage," Chan said.

(Reporting by Gertrude Chavez-Dreyfuss; Editing by Kenneth Barry)