Inflation is killing the dollar carry trade in emerging markets

The temporary improvement for dollar-funded emerging market carry trades appears to be over, as a pick-up in US inflation makes the outlook increasingly treacherous.

A Bloomberg index of these bets has fallen more than 4% in the past two months, the biggest drop since March 2020 for a strategy of borrowing in dollars and investing in developing country currencies.

The fastest US inflation in three decades is putting pressure on the Federal Reserve to tighten its monetary policy, raising the prospect of higher costs for dollar borrowers and less additional yield, or carry trade.

It’s a rapid change for operators, who just two months ago were accommodating to the expansive message of the Fed on the gradual pace of adjustment and were seizing the opportunity to accumulate carry trades. Many of these bets are now being undone due to growing concerns about inflation and whether central banks will have to catch up on aggressive hikes.

“Much higher-than-expected inflation readings in the United States and China will wreak havoc on the narrative that inflationary pressures are transitory.“, said Mitul Kotecha, Chief Emerging Markets Strategist for Asia and Europe at TD Securities in Singapore. “This bodes ill for EM carry trades in the short term as it narrows the relative performance gap.”.

A tightening of global liquidity conditions due to the fact that the Fed Reduced its asset purchases may also create some hurdles for EM carry, he said. Kotecha.

Traders could turn to the euro and the yen to lower financing costs. Both currencies are among the worst performers among the Group of 10 so far this quarter, with the European Central Bank and the Bank of Japan Maintain an accommodative posture.

Losses in the Bloomberg emerging markets carry trade index since late August come after a 1.5% rally that month. The indicator, which covers eight currencies, including the Brazilian real, the Mexican peso and the Indian rupee, is heading for a second annual loss.

Among the worst performing operations in the past two months, trade in dollar loans and purchases of Turkish liras has lost 12%, while investments in the South African rand and Hungarian forint have fallen more than 4%. On the positive side, allocating funds to the Argentine peso has had a 7% return.

At least some emerging market central banks are expected to raise interest rates quickly enough to guarantee a yield premium that improves carry trade returns. Investors can get more guidance on this this week with the policy decisions of South Africa, Indonesia, the Philippines and Hungary.