Getting carried away with emerging market carry trades
Investors appear to be getting carried away with their exposure in emerging markets, where sentiment could change in a heartbeat
For emerging markets, the last 12 months have been a roller-coaster ride.
In May last year, the US Federal Reserve's hint that it would begin scaling back, or "tapering", its asset purchases sparked a disorderly sell-off in emerging markets.
Then, in January, just when it seemed that sentiment towards developing economies was improving, concerns about China's economy and the plethora of idiosyncratic risks in emerging markets caused a sharper, and more indiscriminate, sell-off.
Since March, however, investors have become positively bullish about emerging markets. The shift in sentiment is being driven by the reach for yield, fuelled by a sharp and unexpected rally in benchmark US Treasury bonds.
The yield on 10-year US government debt has fallen from three per cent at the beginning of this year to 2.5 per cent, whetting investor appetite for higher-yielding assets.
In the week to May 14, emerging bond funds, which have suffered nearly US$9 billion in outflows this year (more than the US$6.2 billion in inflows last year, to say nothing about the nearly US$100 billion in inflows in 2012), registered their seventh consecutive week of inflows.
According to Bank of America Merrill Lynch, which tracks non-resident holdings of local currency debt, foreign investors are once again increasing their exposure to the domestic bonds of developing economies, in particular Asian and Latin American bonds.
This increase in foreign demand is driving up the price of emerging-market debt.
The yield spread between US dollar-denominated emerging-market debt and US Treasuries, which had risen to roughly 400 basis points - or 4 percentage points - in January, has fallen to just over 300 basis points - a mere 25 basis points above its level just before the Fed let the tapering genie out of the bottle.
The sharpest compression in emerging-market spreads is occurring in higher-yielding markets, as the carry trade - borrowing funds in low-yielding currencies, such as the yen and the euro, to invest them in higher-yielding assets - comes back into fashion.
Yet the higher-yielding markets have higher yields for a reason: they are invariably riskier than their lower-yielding counterparts.
The question is whether investors are pricing country-specific risk in emerging markets correctly and, just as importantly, whether the rally in US Treasuries is sowing the seeds for a market correction.
Simply put, are the carry traders getting carried away?
As the International Monetary Fund notes in a recent report, the market to keep a close eye on is emerging Europe, because of its large external funding requirements.
One of the most popular carry trades this year has been in the Turkish lira, which has strengthened 9.5 per cent since the end of January.
Given that Turkey is still running a large current account deficit - which last year amounted to a staggering 8 per cent of gross domestic product - financed almost entirely by inflows of hot money - and that the credibility of Turkish monetary policy is still in doubt, investors may be getting ahead of themselves.
Indeed, it was only four months ago that Turkey was the focal point for market nervousness about emerging markets.
Still, at least investors in Turkish assets are being compensated with double-digit interest rates and a juicy yield on two-year local currency bonds that is still 4 percentage points higher than where it stood a year or so ago.
The risk-reward balance in Hungary, on the other hand, is becoming less and less attractive.
Although more stable than Turkey, Hungary has a much larger external and public debt burden, a large stock of foreign currency-denominated debt and much higher foreign participation in its local debt market.
What's more, Hungary's steadfastly dovish central bank has slashed its main interest rate to just 2.5 per cent amid the emergence of deflation. This is on a par with borrowing costs in Poland, a country which is also flirting with deflation but has much stronger fundamentals.
The yield on Hungary's 10-year local currency bonds, now at 5.1 per cent, is lower than when the Fed hinted at tapering. Even Poland's 10-year yields are still significantly higher.
This is as good an indication as any that risk is being underpriced in Hungary.
Another, and more important, source of risk that the carry traders may be underestimating is the possibility of a sharp correction in financial markets.
The remarkably low volatility in markets, accentuated by the extremely low yield on the 10-year US Treasury note, could prove deceptive and may be the prelude to an abrupt and dramatic shift in sentiment.
There are already signs that the rally may have run its course. Yields on euro-zone peripheral bonds, notably Portugal's, are beginning to rise again - albeit from exceptionally low levels - while global stock markets, particularly US equities, are wobbling.
This suggests that it won't take much for sentiment towards emerging markets, which have yet to contend with a rise in US interest rates, to deteriorate again.
Judging by the mispricing of risk in Hungary, the carry traders are on thin ice.
Nicholas Spiro is the managing director of Spiro Sovereign Strategy