EM currencies investors walk a tightrope between risk and return

Yield-hungry investors are facing a dilemma. Are the higher returns they can earn in emerging markets worth the risk, now that the outlook for global growth is darkening? At the end of last year investors could not get enough of such assets, making the so-called carry trade (where traders borrow in a low-yielding currency to buy a currency with a higher rate) a very crowded bet. But for such wagers to perform, conditions need to be just right.

When the dollar strengthens, EM currencies tend to weaken, wiping out gains on the carry trade. Volatility, which measures the degree of price swings in the exchange rate, needs to be low while broader sentiment in the market needs to be calm. Since February however, concerns about global growth have intensified, culminating in a rush to the relative safety of government bonds last week.This is bad news for any investors trying to pick up yield from riskier assets, as growth worries can spur sharp sell-offs in EM and wipe out any gains from interest rate differences. Sell-offs can also be exacerbated by the popularity of the trade, as in times of stress; bets are often closed out at the same time.

In January, JPMorgan’s flagship EM bond and foreign exchange index registered a 5 per cent return as indices snapped back, and so far this year it has returned 3.8 per cent. This compares favourably with the 2.5 per cent yield that investors can get by simply borrowing the euro to buy US dollars. But in some countries, for example Russia, investors can still earn as much as 6 per cent in real terms from a euro-funded carry trade, provided that everything goes to plan. There is plenty of money waiting to be invested and not a lot of yield available. Volatility remains low and interest rates across EM are at multiples of their developed-market peers. This means that EM trades continue for now to be attractive.