Emerging-Market Carry Bulls Back Trade as US Yields Top 5%

Investors are sticking with emerging-market carry trades, even after a rare quarterly loss, betting the strategy will be able to weather Treasury yields at multi-decade highs

Ninety One Ltd., Generali Asset Management SpA and William Blair BV are among the money managers who see last quarter’s loss — the first in two years — as just a hiccup for dollar-based carry trades. That’s because the strategy — borrowing dollars to buy higher-yielding assets in the developing world — hinges above all on a stable greenback, and investors are not convinced its recent bounce will extend.

After six straight quarters of gains, the trade lost money last month in 16 of the 20 most popular currencies. That was enough to push the entire July-September period into the red, a gauge compiled by Bloomberg shows.

Yet for many investors, 10-year Treasury yields above 5% won’t necessarily wreck the trade. The speed of last month’s Treasury selloff rather than the yield level caused the damage, according to them. Perhaps more crucially, few expect a sustained dollar rally — historically the key transmission channel for stress into emerging markets.

“High US yields are not necessarily fatal for EM carry,” said Yvette Babb, a portfolio manager at William Blair. “The recent setback in EM carry is more likely to prove a reset in positioning than the start of a wholesale unwind.”

Read: Emerging Markets Can Weather Fed Risk After Oil Jump and War

The carry trade does face risks. The Federal Reserve is likely to raise interest rates, while Treasuries are offering the highest returns since 2007. The extra yield investors receive to compensate for emerging-market risk has all but vanished. The dollar, meanwhile, has hit three-month highs, helped by fears of a crisis in France.

“The risk-reward calculation has changed,” said Nick Rees, head of Macro Research at Monex Europe Ltd. “Treasuries look increasingly attractive, both from a yield perspective, and as protection in case the recent rapid rise in yields breaks something in markets.”

Even so, the dollar’s advance is relatively modest when compared with previous bouts of Treasury turmoil. In the five weeks through Sept. 28, average Treasury yields surged 66 basis points, while a dollar index compiled by Bloomberg firmed just 2%, remaining below this year’s highs.

“What matters the most is the USD,” said Guillaume Tresca, a strategist at Generali Asset Management. “It acts as a shock amplifier. If rates stay high but USD is OK, carry trade can still perform.”

Carry trades managed to successfully weather Treasury selloff earlier this year. Back then, yields rose but the dollar did not, because concern over US government spending, rather than monetary policy, drove the move. September’s bond rout, however, was more painful for carry trades; because it was spurred by rate-hike expectations, it ended up boosting the greenback.

Thys Louw, a portfolio manager at Ninety One says bond markets are repricing to take into account higher energy costs, resilient global growth fueled by hyperscalers’ capital spending and increased borrowing by rich nations. However, he doubts yields will continue rising at last month’s pace.

“We are likely closer to the end rather than the beginning of this repricing,” Louw said. “Thus expectation is that we are close to peak volatility.”

Investors’ worries over US fiscal credibility and their desire to diversify from dollar assets should also support carry trades, he expects.

William Blair’s Babb has become more selective. With market volatility making buy-everything carry strategies less reliable, she’s focusing on countries with credible policy making, high yields and strong balance-of-payments positions.

“The next phase of the carry trade is likely to be narrower and more idiosyncratic than the broad-based carry rallies seen in some previous cycles,” she added.

What to Watch

Markets will react on Monday to the results of Brazil’s first-round presidential vote Sunday that pits President Luiz Inácio Lula da Silva against Senator Flávio BolsonaroThe Czech Republic will hold Senate and municipal elections on Oct. 9-10. These will be the first electoral test of Andrej Babis’s government, with 27 of 81 Senate seats contestedSlovenia holds four referendums on Oct. 11, covering parliamentary investigations, welfare benefits, voting rights for non-Slovenian EU citizens in local elections and the public-broadcasting feeThe South African Reserve Bank’s monetary-policy review is due TuesdayOn Wednesday, India’s central bank will announce its benchmark repurchase rate. The key question is whether it starts a tightening cycle amid war-led inflation pressuresPoland may hold its base rate at 3.75% on Wednesday. Kenya and Sri Lanka will also announce their decisions the same dayPeru , Uruguay, Romania, Tanzania and Serbia will decide on interest rates on ThursdayColombia’s monetary-policy minutes due Tuesday, Mexico’s Thursday and Poland’s Friday