Carry trade returns to generate strong profits in Latin America

The carry trade is coming back strong Latin Americaa region that is home to some of the world’s most aggressive central banks in fighting inflation.

The sharp rise in interest rates across the region, from Chile to Brazil to Mexico, contrasts sharply with the United States and Europe, where policymakers continue to keep borrowing costs close to zero, though they are closer to zero. raise rates. This is benefiting a tactic that takes advantage of this disconnect: borrowing in the US and Europe, then investing the money in countries where bond yields are significantly higher.

The US-Brazil carry trade—that is, borrowing US dollars to buy reais—has generated a return of around 8% in the past month, as the Brazilian currency has risen more than any other currency in the world. the world of emerging markets, according to data compiled by Bloomberg. A broader carry trade index returned 4% in January thanks to strong gains in the currencies of Peru, Chile and Colombia. Another index, which includes investments in South Africa and Russia, has also generated returns this year.

Andreas König, head of global forex in London at Amundi, Europe’s largest asset manager, said he expects carry trades to continue to bear fruit as global economic growth continues to recover from the pandemic and stock market volatility. foreign exchange remains relatively low.

“Several emerging market currencies could do quite well in this context,” he said. “When we talk about carry trades, we have to look at those with attractive interest rate spreads. My favorite candidates are Brazil, Russia, Mexico, South Africa, Chile and Colombia”.

The recent gains mark a turnaround for this type of trading in the developing world, which faced headwinds last year when the US dollar staged its biggest rally since 2015, while Treasury yields and stock prices rose thanks to the acceleration of economic growth. That dollar bull run helped dampen interest in the carry trade, even as large gaps in monetary policy emerged last year.

However, in 2022, the dollar has been relatively stable. And while bond markets in Europe and the US have been shaken by the specter of rising interest rates, yields remain far below those in the developing world.

Goldman Sachs Group Inc. is among those backing carry trades, suggesting investors buy Chilean and Mexican pesos with loans financed in euros and Australian dollars.

The tactic carries significant risks by leaving investors exposed to potential reversals in currency markets. That possibility looks particularly high now, given that European and US bond yields are rising as the Federal Reserve withdraws pandemic-era stimulus and the European Central Bank pivots toward tightening monetary policy. This rise in yields could draw cash away from emerging markets, which in turn could push down their currencies and jeopardize carry trade gains.

But that is partly offset by how far ahead of the Fed and ECB are emerging market central banks, neither of which have yet raised rates. In Latin America, which has suffered painful bouts of hyperinflation, central banks have taken aggressive steps since last year to raise rates, denting economic growth and pushing Mexico and Brazil into recession.

However, rate hikes have also pushed many Latin American currencies higher. And officials have a strong incentive to accept this, and prevent their currencies from depreciating, as it can help contain inflation by keeping import prices low.

“Monetary policy remains well advanced in emerging markets,” Morgan Stanley strategists including Matthew Hornbach wrote in a note. “If you’re looking for proactive central banks that will deliver ever-higher returns, then you should look to emerging markets.”

FX market volatility, which can pose another risk to carry trades, has remained relatively subdued: the JPMorgan Global FX Volatility Index has retraced from highs seen late last year and remains below its average of two decades.

There are also questions about the extent to which the Federal Reserve will be able to tighten monetary policy without derailing the economic expansion. Even if it makes five quarter-point hikes this year, as markets expect, the lower band of the overnight rate would still be just 1.25%. And the narrow gap between short-term and long-term Treasury yields indicates concern about slowing growth.

“There could be wealth destruction if the Fed tightens too much,” said Jack McIntyre, a portfolio manager at Brandywine Global Investment Management, which is overweight emerging market currencies including the Chilean and Mexican pesos and the Brazilian real. “When the rest of the world is experiencing strong economic growth, the dollar can underperform. And in an inflationary world, central banks and governments tend to welcome, or at least not oppose, stronger currencies as a way to fight inflation.”