Dollar vs euro: which is the best source of funding for emerging-market carry trades?

Weakness in both the dollar and euro is posing a dilemma for investors about which is the best source of funding for emerging-market carry trades. On balance, the US currency is still first choice.

The dollar has been sliding since the second quarter of 2020, as the Federal Reserve cut interest rates to a record low and spiralling coronavirus infections pummelled the United States economy. The euro has begun a swoon of its own in recent weeks, briefly dropping below the key US$1.20 level, as delays in coronavirus vaccinations set back expectations for a European economic recovery.

“We continue to favour the dollar as our funding currency in emerging-market carry trades,” said Norman Villamin, chief investment office for wealth management in Zurich at Union Bancaire Privee, which oversees the equivalent of US$166 billion. “Though the euro has weakened on the back of concerns about vaccine roll-outs of late, we expect this is temporary and will reverse as vaccine roll-outs accelerate on the continent.”

The challenge in seeking the best funding currency comes as emerging-market central banks start to signal tighter monetary policies as their economies recover from the coronavirus pandemic. The hawkish pivot should help breathe life into carry trades, which have languished during a period when yields have been at rock bottom around the world.

Both the dollar and euro have been losing ground versus their developing nation peers. The US currency has declined versus 17 of 22 emerging-market currencies in the past six months, while the euro has dropped against 16 of the same group this year.

A strategy of borrowing dollars and investing in a basket of 10 emerging-market currencies at the start of this year would have returned 0.8 per cent, according to data compiled by Bloomberg. A similar trade funded in euros would have already gained 2.1 per cent.