Carry Traders Use the Weak Euro to Win Big in Emerging Markets

(Bloomberg) – For carry traders battered by the rallying dollar and rising US borrowing costs, the euro’s worst fall since 2005 couldn’t have come a moment sooner.

According to data compiled by Bloomberg, investing in emerging market currencies with borrowed euros returns up to 29% this year depending on the choice of the highest yielding currency. Gains are driven by the euro’s 10% decline against the dollar, which took the cross to parity for the first time in two decades.

Those who funded the same carry positions with the greenback had far less lucrative results: not only did the overall strategy fail for the third year in a row, but most emerging market currencies also produced losses. Even in Latin America, profits have stalled after a meteoric start. Needless to say, traders change.

“Financing carry trades by selling euros is becoming more commonplace,” said Brendan McKenna, currency strategist at Wells Fargo in New York. “The European Union looks more likely to fall into recession and geopolitical developments should weigh on the currency, making emerging market carry trades financed by the euro an attractive option.”

Euro-funded carry trades offer a safe haven for emerging market traders, who are suffering losses across all asset classes and strategies amid soaring dollar and US yields. The bear market in developing-country equities is deepening, a local-currency bond index is at a two-year low, and dollar bills are posting the biggest declines since 1994. If the outlook for a recession in United States and a tightening of the Federal Reserve continue to fuel a run on the dollar, the carry of the euro could well become irresistible for more investors.

There are already signs that the trade will remain profitable for at least the rest of the year. With the Eurozone in recession, the ability of the European Central Bank to aggressively raise interest rates is limited. This means that the gaping interest rate gap between emerging markets and the continent is unlikely to narrow, clouding the outlook for the common currency.

“It doesn’t look good for the euro in the second half,” said Marek Drimal, chief strategist for Central and Eastern Europe, Middle East and Africa at Societe Generale SA. “Even if the ECB surprises with another big hike, there are still substantial risks to the euro before we see a turnaround.”

Exceptional Weakness

It is not always true that the weakness of the euro gives emerging market currencies a carry advantage. More often than not, weakness on one side coincides with losses on the other, leaving little room for arbitrage. But this time, the rise of the dollar has been more detrimental to the euro than to the exchange rates of developing countries.

The Chinese yuan hit its highest level against the euro since 2015 in July. The Indian rupee and the Mexican peso touched the highest levels since February 2020. Indeed, 18 of the 23 currencies tracked by Bloomberg are higher against the euro than at the start of the year.

Further clues to the euro’s outlook could emerge this week as the onset of the summer holiday peak lowers trading volumes and fuels volatility. The common currency has recorded losses in August in 10 of the past 15 years. Investors will also compare the purchasing managers’ indices of developing countries, including China and India, with those of the euro zone.

“Europe is on the brink of disaster,” wrote Edouard de Langlade, the founder of hedge fund EDL Capital in a letter to clients this month. “We could move to a place where the dollar is not strong against everything but the euro is weakening against everything.”

What to watch this week:

  • China’s PMI indices will likely show the economy taking a hit as mortgage boycotts increase pressure on struggling developers and intensify the housing crisis
  • The Reserve Bank of India is expected to raise its repo rate by 25 basis points in its August 5 review
  • Consumer price inflation in Turkey is expected to rise to 80.6% in June as central bank inaction on key policy lever kept prices unchecked
  • Colombia will publish the minutes of its last monetary policy meeting

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