The return of the carry trade
I F YOU LIKE a central bank that responds to inflation surprises by raising interest rates, and here’s a retro twist, then Banco de México might be the one for you. On June 24, it surprised the markets by increasing its benchmark rate from 4% to 4.25%. Although he said in his statement that much of the recent rise in inflation was “transient,” the magnitude and persistence of inflation was worrying enough to warrant higher interest rates.
Mexico is no exception. Brazil’s central bank raised interest rates to 4.25% after trough of 2% in March. Russia raised its main rate to 5.5% in three separate steps. These countries belong to the high yield countries, a group of large emerging market economies, where interest rates are quite far from the rich world’s zero standard. All three believe that a large part of current inflation will subside. But none of them take any risks.
Scan central bank statements, and one clear concern emerges: controlling inflation expectations. Part of it, if not a large part, is exchange rates. Higher interest rates keep national savings on land in local currency. They also attract capital from foreigners in need of returns. This is called the carry trade and it comes back.
High interest rates are now so rare in large economies that when they do arise, they need to be explained. Latin America has a history of inflation. It’s hard to get people to trust a currency when memories of betrayal linger. A related explanation is the high public debt. Brazil’s burden is approaching 100% of GDP. Tax incontinence in developing countries often leads to inflation. High returns are needed to offset this risk. But such explanations do not get you far. Although Poland experienced an episode of hyperinflation in living memory, it is a low-performing country. Turkey’s yields are high even though the weight of its public debt is well below the emerging market average.
High yields are ultimately a reflection of a lack of domestic savings, according to Gene Frieda of PIMCO, a fixed income fund manager. A telltale sign is a country’s current account balance. From an accounting point of view, a deficit means that domestic savings are not sufficient to cover the investment. Foreign capital is needed and high returns are the lure. Much of emerging Asia has a current account surplus and has high domestic savings – and therefore low returns. Poland and the Czech Republic, both with low yields, were able to reliably increase their domestic savings with EU grants and direct investment by western European companies. Russia, which has high yields and a current account surplus, is an exception. But the surplus reflects its ultra-conservative monetary and fiscal policies, Frieda said. The net effect is to increase yields and reduce GDP growth but strengthen the balance of payments. Russian leaders accept this to avoid being indebted to foreign capital.
This brings us to the carry trade. Policymakers in emerging markets are irritated by the vagaries of capital flows. But carry traders are their friends. The inflation expectations that central bankers insist on are closely linked to the exchange rate. A weakening currency can be a sign of anxiety about inflation. And over the past year, currency weakness has also been a source of inflation in emerging markets, says Gabriel Sterne of Oxford Economics, a consultancy firm. So, when a central bank raises its interest rates, it is partly because it wants a stronger currency to reduce import costs. This is perhaps the fastest way to bring inflation down.
For their part, carry traders like a yield curve that is steep, which means that five- or ten-year bond yields are much higher than short-term interest rates. A steep curve reflects expectations of future key rate hikes. Traders also hope to bet on an appreciating currency. Factors other than interest rates then come into play. One is evaluation. If a currency has fallen significantly recently, it has more room for improvement. Another is a country’s terms of trade, the prices of its exports relative to imports. Oil exporters are now favorable due to high oil prices. Carry traders should be alert to influences that could cause a currency to explode. Turkey has attractive returns, but its erratic monetary policy is creating a minefield.
Brazil, Mexico and Russia are at the forefront of a new trend. Economists at JPMorgan Chase, a bank, believe Chile, Colombia and Peru will soon raise rates. South Africa will join them before the end of the year. The Banco de México and its company are not going to hang a sign saying “transport traders are welcome”. But they might as well put one. The more their currencies increase, the less work they have to do. ■
This article appeared in the Finance and Economics section of the print edition under the title “Continue”