EM Carry Trade Appeal Boosted by Easing FX Swings, Analysts Say

Easing currency volatility is giving fresh support to emerging-market carry trades by reducing risk, according to analysts at Mizuho Securities Co. and Goldman Sachs Group Inc.

EM currency volatility has fallen around 1.3 percentage points this quarter, declining faster than a similar gauge that tracks a Group-of-Seven currencies, according to JPMorgan Chase & Co. data. The ratio between the two indexes fell to its lowest since 2013 last week and the trend may continue with the dollar .

The drop in foreign-exchange volatility comes at a critical moment, with returns from dollar-funded EM carry trades already slipping as the greenback steadies. Central bank interventions have also helped keep swings in check. Because carry trades — which borrow in a low-yielding asset to invest in a higher-yielding one — are highly exposed to short-term FX moves, calmer markets reduce risks.

“Low FX vol works in favor for EM carry trades due to the better carry-to-risk ratio,” said Shoki Omori , chief desk strategist at Mizuho. “EM FX volume is slowing down because realized FX ranges, especially those in Asia, have collapsed with central banks in China, India, Indonesia and South Korea actively smoothing the spot FX to contain volatility and fixings.”

A measure of eight EM carry trades funded via the dollar has slipped in the third-quarter, offering returns of around 1.4%. That compared with over 4%-returns seen in the first two quarters this year, according to a Bloomberg index .

High-yielding EM currencies remain appealing, with three-month forward implied yields in Mexico, Brazil and Colombia at 7% or higher. With FX volatility easing, investors are more confident that swings in spot exchange rates won’t eat into those returns.

“Broader decline in volatility pricing across asset classes” is supportive for EM carry performance, wrote Goldman Sachs strategists including Kamakshya Trivedi and Danny Suwanapruti in a note on Wednesday.