| LONDON/NEW YORK
LONDON/NEW YORK Jan 28 A sell-off on emerging
markets is likely to flush out many of the remaining carry trade
investors who went there in search of higher returns, and this
shift should boost more liquid currencies such as the dollar,
yen and Swiss franc.
Some investors fear the U.S. Federal Reserve may slow the
flood of money it has pumped into markets more sharply than
expected. This, along with the likelihood that other major
central banks such as the Bank of England will also tighten
policy as developed economies recover, may spell an end to the
ultra-cheap cash used to fund emerging market investments.
About $4 trillion poured into emerging markets in the
aftermath of the 2008 global financial crisis as the major
central banks cut interest rates close to zero and flooded the
system with liquidity through huge bond-buying programmes.
Investors piled into carry trades - borrowing in
low-yielding currencies to buy higher-yielding ones to achieve
better returns. A recovery led by China drove them to sell
dollars, yen and Swiss francs, where central banks
have anchored interest rates near zero, for emerging markets and
higher-yielding currencies in the developed world such as the
These trades have been unwinding for several months,
particularly since last May when Fed Chairman Ben Bernanke
suggested the U.S. central bank might start scaling back the
supply of cheap funds. This process finally began in January.
Steven Englander, head of G10 currency strategy at Citi,
said some clients were worried the Fed may end up raising
short-term interest rates sooner than expected. That will push
up U.S. bond yields, making the dollar less attractive as a
funding currency in carry trades.
"Undoubtedly it's the case that if they tighten quicker than
anyone thought, there will be a bloodbath," he said.
The rush for the exit has intensified, prompted by signs
that the Chinese economy is slowing and crisis in a number of
emerging nations including Argentina, Turkey and Ukraine. All
this has led to fears of a domino effect in emerging markets, as
in the 1990s.
Higher yielding developed currencies have become caught up
in the sell-off. The Australian dollar hit a 3-1/2 year low
while another currency sought by carry trade investors, the
Canadian dollar, fell to a four-year low.
Speculators ramped up short-selling bets against the
Australian dollar in the week to Jan. 21 to their
highest since early September, the Commodity Futures Trading
Commission reported. That was in sharp contrast to the huge long
positions they ran between 2009 to 2012.
They have even turned against the Mexican peso, a
liquid emerging market currency, for the first time since
Reflecting the souring sentiment, Deutsche Bank's FX carry
trade basket - an industry index that tracks these trades -- has
shed more than 8 percent from a peak last April and nearly 2.5
percent last week alone.
"Rising tensions in various emerging market countries around
the globe are starting to have a significant impact across asset
classes," said RBC Capital analyst George Davis. "Of particular
note has been the collateral damage that has been done to FX
CARRY OFF THE TABLE
Selling low-yielding currencies in favour of higher-yielding
currencies has generated 5 percent annual returns to investors
in the past three decades, according to a study by the Cass
Business School released in late 2012.
It is a popular strategy amongst fleet-footed investors,
speculators and banks looking for better returns. But the Fed's
decision to taper the economic stimulus has hurt returns, and
many investors have already withdrawn from them as the sell-off
in currencies from Turkey to Argentina picked up pace.
Profits from carry trades can be quickly wiped out if the
target currency falls. The Turkish lira, for instance, has lost
more than 15 percent against the dollar since Dec. 17 alone.
So far, there are few signs that the stress in emerging
markets will spill over to developed economies leading to large
scale turmoil in developed markets, as was seen in 1997/98.
Alessio de Longis, who runs the Currency Opportunities Fund
at Oppenheimer Funds, said many of these bets had already been
unwound, so the rout need not cause a re-run of the 1990s
In the wake of the 1997 Asian crisis and the 1998 Russian
collapse that brought down one of the largest hedge funds at the
time, the Fed stepped in to rescue the system along with the
U.S. Treasury and the International Monetary Fund.
The Fed is unlikely to halt its tapering programme when it
meets this week due to the turmoil in emerging markets.
Nevertheless, the uncertainty has caused a jump in market
volatility which will curb demand for risky trades.
Investors will also worry about the worsening outlook for
Chinese economic growth and turmoil in its banking sector. The
authorities narrowly avoided a default of a $500 million
investment trust this week.
"Heavily short any of the major currencies is a very
dangerous position to be in," said Karl Schamotta, director of
FX strategy at Cambridge Mercantile Group, Toronto.