Arbitrage trading is fleeing from emerging markets

As the dream of a Fed rate cut shattered and the Middle East powder keg ignited, in a corner that few people pay attention to, the carry trade is fleeing from emerging markets outside of Asia.

Starting from April 8th, previously high-yielding emerging market currencies such as the Mexican Peso and the Polish Zloty, which had previously set new highs for the year, experienced a sharp and rapid decline, wiping out all gains for the year. Among them, the Mexican Peso suffered the most brutal decline, retracting by 4.7% from its high, with such a huge volatility that is jaw-dropping.

Since 2022, benefiting from the transfer of the manufacturing industry supply chain and the attractiveness of high interest rates, the performance of the Mexican Peso has been outstanding, being called the "super Peso" by emerging market traders. Borrowing in funding currencies such as JPY and CNH to buy high-yielding currencies like MXN and INR once became the best trade, indirectly driving the strength of currencies like the Indian Rupee and the Brazilian Real. This sudden drop is related to recent expectations of intensive changes.

1. Long and short-term yield rise, USD hits new highs for the year

Better-than-expected economic data knocked the bullish sentiment for US bonds, even Powell had to admit that inflation is facing downward pressure, and the high-interest rate environment will last longer. The two-year US Treasury yield rose to the 5% mark, and the US Dollar Index also stood firm at 106, delivering a blow to emerging markets.

2. Middle East crisis triggers safe-haven demand

The escalation of the Israel-Palestine conflict to the Iran-Israel conflict, although both sides have calmed down after exchanging blows, commodities and oil prices have already priced in potential risks. Under deteriorating risk sentiment, traders are embracing the US dollar again.

3. Rising implied volatility, carry trade cost-effectiveness declines

Compared to the absolute level of interest rate differentials, Carry/Vol is a more important factor for traders. Since April, the implied volatility of the Mexican Peso has risen significantly from 1 month to 1 year, making carry trades less cost-effective, leading to a large retreat in positions.

After checking the latest views of foreign banks over the weekend, it was found that they have all turned to a bullish view on the US dollar, with Nomura believing that the Euro may fall to 1.05. Considering the clear theme of policy differentiation between the Eurozone and the US, the May FOMC meeting is likely to be hawkish, and the strength of the US dollar is becoming the consensus for the year.

In my opinion, although the Japanese Yen continues to hit new lows, the likelihood of actual intervention by the Bank of Japan remains low, as the current exchange rate level is not deviating from the fundamentals and has not triggered systemic risks. USDJPY is steadily moving towards 155. Compared to the continuously depreciating Yen, the Renminbi's central parity rate remains stable, and CNH liquidity is relatively tight, with implied volatility retracting. **It is expected that the Renminbi will continue to fluctuate narrowly, with the central axis of USDCNY slightly moving upwards **

Author: Li Haoran, Source: Morning Market, Original Title: "Exiting Carry Trades from Emerging Markets on April 23, 2024"