Morning Brief – Tuesday 9th

Swing Low

The carry trade is a favourite in foreign exchange (or indeed any) investment: use something cheap to buy something rewarding that you hope in turn is still worth something at the time you decide to cash your chips in. For example, with the Rand yielding 6.75% due to its underlying interest rate and the Euro in negative territory, you can achieve a solid profit by borrowing Euros for one year and purchasing Rand (enjoying the interest) so long as in 12 months’ time the Rand hasn’t fallen by 6.75% (not a guarantee many of you will note!). Now, with the Eurozone and Fed moving further down the path of monetary loosening, the relative reward of this trade gets even bigger, enticing demand into the market for emerging market currencies to the detriment of both major currencies. The evidence is clear: since mid-May when the debate about US monetary easing and the Eurozone perhaps restarting it’s buy everything policy, that very trade has become 4% more expensive when measured with a basket of 8 emerging market currencies.

But the risk behind this strategy and therefore the strength of emerging market currencies in general is sizeable. Yesterday served as a strong reminder of the risk that many emerging markets pose. Turkey by presidential decree removed Mr Cetinkaya from the post of central bank Governor only three years into a term of four following a year long disagreement over what appropriate monetary policy is. President Erdogan detests high interest rates believing that they constrain business by making the acquisition of money too pricey. Attacking one of the very virtues of an emerging market currency saw the Lira face its worst day in months selling off by 3% by the time yesterday was out. That’s a big chunk of any carry trade yield wiped out (43% for Euro funded Turkish carry trades) already so markets will continue to question the viability of the Lira as an investment in days to come. Investors will beg that Mr Erdogan read an economics text book and learn how money works. However, given his self-afforded status as a quasi-dictator perhaps there’re books that ought to be higher up the list!

Nonetheless emerging markets continue their rally but will face a tough assessment as we are offered the ECB’s and the Federal Reserves’ minutes from their last meetings this week. Any evidence that markets have overpriced the degree of easing that the respective boards are considering will have a net-negative impact upon emerging markets whilst raising the value of the Euro and US Dollar against their peers. With CFTC data released yesterday, we can now confirm that further conviction was added to the expectation of US economic weakening to the benefit of emerging markets. Long positions on the US Dollar were seen to have fallen but admittedly still remain the prevalent trade.

The same data confirmed investors’ condemnation of the Pound with short positioning reaching its highest level since September 2018. That means that registered money betting on a fall in Sterling has reach its highest level versus bets that believe it will rise in 10 months. Moving towards the leadership contest finale, expect a volatile Pound. It was a dire day for the Pound yesterday, falling towards (and overnight through) important areas of resistance particularly against the US Dollar. The fall occurred despite positive signals from EU Commission President nominee Von der Layen who mentioned that an extension to the Brexit deadline is permissible.

Discussion and Analysis by Charles Porter

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