Source: Zhitong Finance
This year, the strategy of borrowing in emerging market currencies and buying dollars brought returns as high as 9%.
For decades, arbitrage traders have used low-interest dollars to invest in higher-yielding emerging market currencies. However, as the Federal Reserve continues to tighten monetary policy, this trend is being reversed, and some emerging economies are struggling to maintain the competitiveness of their yields and have become targets for reverse arbitrage transactions. This year, the strategy of borrowing in emerging market currencies and buying dollars brought returns as high as 9%.
The currencies involved in this transaction include Thai baht, Malaysian ringgit, and even the Czech koruna. Although traditional arbitrage transactions are still ongoing, involving investments in high-yield currencies such as Mexican pesos, Turkish liras, and Egyptian pounds, more and more capital is being raised through other emerging market currencies such as yen and Swiss franc rather than the US dollar.
Paul Greer, fund manager of Fidelity International, said in London: “We prefer to hold trading positions between the US dollar and Asian currencies. We like to use Asian currencies with low beta coefficients (low market fluctuations) and low returns as a source of capital, and also adopt the same strategy for the euro and the Czech koruna because we are pessimistic about the growth prospects of these currencies.”
Figure 1
As investors delayed expectations of US interest rate cuts from March to December, monetary policy relaxation in some developing countries appeared premature. This also means that arbitrage traders who use dollar funds to invest in emerging markets are suffering the worst losses since 2021, as they find themselves holding high-risk currencies with minimal or even negative returns.
According to our understanding, the challenges faced by traditional arbitrage exchanges come from two aspects: currency trends and yield differences. In the face of a strong US economy and continued monetary tightening, the stability of the US dollar led to losses in 29 of the 32 most widely traded emerging market currencies this year. At the same time, benchmark borrowing costs in at least 11 frontier and emerging markets are lower than US policy interest rates, making relative bond yields negative.
Manik Narain, head of emerging market strategy at UBS Group, said that currently holding the currency of some countries, including China and South Korea, requires payment of costs. Although Asian countries dominate this negative spread (negative-carry) phenomenon, in some other emerging market countries, this spread buffer is also gradually decreasing. Negative interest spreads mean that the cost of holding a currency is higher than the benefits of that currency, usually due to lower local interest rates or currency depreciation.
Figure 2
The bank expects emerging market currencies to continue to lag behind the US dollar, and advises investors to take reservations about any exchange rate increase. The bank's strategist Narain pointed out that although strong consumer spending in developed countries prompted central banks to maintain hawkish policies, this consumption-driven demand has not spread to global trade. This situation leaves emerging markets without the growth momentum to support their currencies.
Simon Harvey, head of foreign exchange analysis at Monex Europe Ltd, said that now not only are speculators, but also exporters prefer the US dollar because of its higher yield. Over the past few months, many customers have kept their earnings in dollars to avoid exchanging them back to their home currency.
However, there are also other large financial institutions that have different views on the future of emerging market currencies. Among them, Citi and J.P. Morgan are optimistic about the future performance of riskier currencies, believing that these currencies may rebound due to a slowdown in interest rate cuts or because they are oversold.
Overall, however, if emerging markets adopt a more hawkish monetary policy stance and the Federal Reserve's easing policy is not expected to be further delayed, then arbitrage transactions using US dollar funds may be mitigated to a certain extent. Currently, fund managers disagree on arbitrage and currency trends for the rest of the year, and tend to adopt a strategic attitude to flexibly adjust investment strategies according to market conditions.