Volatile Pound Stokes Life Into Emerging-Market Carry Trades

LONDON (Capital Markets in Africa) – There’s life in the great emerging-market carry trade yet, although now it comes with a twist.

Investors are betting a trade that reaped returns of more than 20 percent last year for borrowing dollars to buy Brazil’s real, Russia’s ruble and South Africa’s rand has further to run — only they’re using the battered British pound to fund long positions in emerging-market currencies. Citigroup Inc. on Monday named shorting the pound against the Russian ruble its top trade of the week. 

The so-called carry trade, in which investors borrow in countries with low rates to invest in higher-yielding assets, lost some of its appeal late last year as rising U.S. borrowing costs bolstered the greenback and Donald Trump’s election damped appetite for risk. Now the pound’s volatility, sparked by the U.K.’s move to pull out of the single European market, is making developing markets look like a relatively safe bet.

“Sterling is as volatile as any emerging-market currency at the moment,” saidBen Kumar, the London-based investment manager at Seven Investment Management, which oversees about 10 billion pounds ($12 billion) and is adding to holdings in emerging-market local-currency bonds. “The currency risk is much easier to take than emerging-market currencies versus the dollar.”

The pound’s wild swings have closely tracked every new piece of information on the British government’s Brexit plans. The currency plunged more than 1 percent on Monday, then surged more than 3 percent on Tuesday after Prime Minister Theresa May said U.K. lawmakers will get a vote on the final deal for the nation’s exit from the European Union. The pound weakened 0.8 percent to 1.2313 dollars by 10:30 a.m. in London, taking its decline in the past 12 months to 13.4 percent.

A measure of the pound’s price swings against the dollar in the past week climbed to 23.7 percent on Wednesday, the most after Turkey’s lira among 16 major developed-nation and emerging-market currencies. One-month implied volatility, based on prices of options to buy or sell the pound against the dollar and seen as a gauge of trader’s expectations for future gyrations, climbed to a three-month high.

High Rates
Many emerging-market countries offer attractive carry-trade opportunities because they were forced to push up interest rates during the 2015 commodity crash. South Africa’s central bank lifted its policy rate four times in the past two years to 7 percent, where it will remain in 2017, according to a Bloomberg survey of economists. Russia’s benchmark rate will stay above 8 percent, the survey shows. 

Those relatively high rates, together with currency gains against the dollar, garnered carry returns of 32 percent for the ruble and 21 percent for the rand in 2016. Using the pound as a funding currency, returns in the first two weeks of this year were 4.2 percent for the ruble and 2.5 percent for the rand.

In Russia “we expect the significant real rate levels to persist for a period of time given the central bank’s focus on engineering a reduction in inflation expectations,” bolstering the pound-ruble carry trade, analysts at Citibank including Luis Costa said.