February 13, 2018 / 3:30 PM / in a year

Higher global bond yields, volatility undercut Asian carry trades

(Reuters) - As global bond yields rise concurrently for the first time in years, investors are being forced to review the cost of parking billions of dollars in high-return emerging market assets.

The spurt in bond yields has also pushed expectations of stock and currency volatility to their highest in years, giving investors further reason to re-evaluate their holdings of Indonesian, Malaysian and other Asian assets.

The rise in yields was sparked by fears of a return of inflationary pressures in the United States, which might spur the Federal Reserve into raising rates more frequently than currently priced in, alongside growing prospects for Europe and Japan to wind down their crisis-era monetary stimulus.

The U.S. 10-year Treasury yield touched a four-year top of 2.9 percent on Monday. It has risen about 50 basis points this year.

Particularly at risk are the borrow-low, invest-high “carry” trades, wherein investors who have leveraged on cheap dollars and yen buy higher-yielding emerging market bonds and equities.

“Rising yields are not necessarily a bad thing. But if there is a very significant increase in yields in a short period of time, then that is quite negative for carry trades,” said Chang Wei Liang, an FX strategist with Mizuho Bank.

The surge in bond yields has prompted investors to switch from equity markets to bonds and thus increased volatility in the financial markets, Chang said.

Already, stock exchange data shows foreigners have sold about $8.3 billion worth of Asian equities so far in February.

Indonesia finance ministry data showed foreigners had sold $566 million in the country’s debt markets this month.

“The rise in volatility and U.S. Treasury yields have made Indonesian rupiah carry trade plays less attractive and this has affected foreign flows into Indonesian assets,” a Maybank report said.

The CBOE volatility index, the closely followed “fear-index” measure of expected near-term U.S. stock market volatility, jumped to a 2-1/2-year high of 50.30 percent last week. It was last trading at 25.61.

Implied volatilities, derived from option prices, indicated Asian currencies are likely to see sharp swings in the coming days. The one-month dollar-rupiah implied volatility has jumped nearly 200 basis points this year to 5.7 percent, while the dollar-rupee implied volatility has also risen more than 100 basis points since January to 5.2 percent.

The Sharpe ratios, which measures volatility-adjusted returns, for the Indian rupee, the Indonesian rupiah and the South Korean won have turned negative this year, according to Reuters calculations. The three currencies’ risk-adjusted returns were more than 3 percent last year.

The rupiah and the rupee are popular carry trades, given their bond yields are among the highest in the region.

Asian currencies’ implied deposit rates, which measure the returns an investor gets on swapping U.S. dollars for the regional currencies, also show a sharp drop this year.

Stephen Innes, head of trading for the Asia Pacific at OANDA, said carry trades executed by borrowing euros or the Japanese yen are riskier in the current environment.

“The market is too unsettled to play anything right now on the carry trade,” Innes said.

“Even if I think about doing a carry trade now, I would do with the dollar, because there is more liquidity in dollar/Asia than others.”

Editing by Vidya Ranganathan and Jacqueline Wong

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