Investors Embrace Unconventional Move to Borrow in Emerging Market Currencies for US Dollar Investment

US Dollar's Surge Sparks Unconventional Emerging Markets Carry Trades

In a groundbreaking shift, investors are now borrowing in high-yield emerging market (EM) currencies to invest in the US dollar, with potential returns of up to 9%. This extraordinary move is driven by the Federal Reserve's tight monetary policy, propelling the dollar to outperform 29 of 32 major EM currencies. UBS advises shorting the yuan against the dollar, foreseeing further depreciation. This trend also impacts exporters, as many choose to retain revenues in dollar deposits rather than converting to their home currencies. While some expect a resurgence in riskier currencies, UBS and others urge caution, envisioning continued EM currency lag behind the dollar.

Key Takeaways

• A new wave of unconventional carry trades sees investors borrowing in EM currencies to buy dollars, offering returns of up to 9% due to the Fed's tight policy.
• The dollar's remarkable performance eclipses 29 of 32 major EM currencies, disrupting traditional carry trades.
• UBS advises shorting the yuan against the dollar, anticipating further devaluation.
• EM currencies grapple with negative relative bond yields amid a robust US economy.
• Exporters favor the dollar for its superior yield compared to conventional EM currency recipients.

Analysis

The remarkable ascent of the US dollar, fueled by the Federal Reserve's rigorous monetary policy, has given rise to an unprecedented carry trade: borrowing in high-yield EM currencies to invest in the dollar. This development inflicts substantial repercussions on EM nations, particularly those with fragile economies and elevated debt levels, as their currencies undergo further depreciation. Financial institutions and fund managers in these regions face substantial losses, potentially leading to a credit squeeze and economic downturn.

Exporters are also impacted, choosing to retain earnings in dollar deposits rather than converting to their domestic currencies, exacerbating currency devaluation. In the long term, this trend could impede EM growth, leading to a decline in foreign investment and a rise in domestic borrowing costs. While some anticipate a resurgence in riskier currencies, major financial institutions like UBS remain cautious, anticipating continued underperformance of EM currencies against the dollar.

Did You Know?

• Reverse Carry Trade: The current scenario represents a reverse carry trade, whereby investors borrow in high-yielding EM currencies to invest in the lower-yielding US dollar, allowing them to benefit from the interest rate differential, yielding up to 9%.

• Tight Monetary Policy: The Federal Reserve's tight monetary policy pertains to the central bank's efforts to mitigate inflation and stabilize the economy by increasing interest rates. This has led the US dollar to outperform most EM currencies, driving the demand for borrowing in EM currencies and amplifying the potential returns of reverse carry trades.

• Shorting the Yuan: Shorting a currency involves selling it with the anticipation of buying it back at a lower price in the future. UBS advises shorting the yuan against the dollar due to the predicted depreciation against the US dollar. The decreased demand for the yuan, resulting from exporters shifting away from traditional EM currency recipients towards the dollar, is expected to drive down its value. Negative relative bond yields in EM currencies, stemming from a robust US economy, further contribute to the potential depreciation of the yuan.