Aussie enters funding phase of emerging markets carry trades

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(Bloomberg) — In a year when shorting the US dollar meant financial harakiri, carry traders’ search for an alternative currency to fund bets in emerging markets has yielded a surprise winner — the Aussie.

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According to data compiled by Bloomberg. The outperformance comes amid a dovish tilt from Australian policymakers since early October that contrasts with the hawkish stance in the United States and Europe.

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With the U.S. dollar falling more than 5% from its record high in September and set to deteriorate after the latest U.S. inflation report, most fund managers are hesitant halt its recovery until the Federal Reserve stops monetary tightening. A Fed pause is unlikely before the middle of next year, however, if money market signals are any indication. This means market volatility will continue and the Australian dollar may well remain a funding choice for carry traders well into 2023.

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“It works best in times of volatility or in a high-risk scenario because the Australian dollar and emerging market currencies will likely move in the same direction,” said Brendan McKenna, strategist at Wells Fargo in New York. “Once the Fed and other central banks have been properly priced by the markets, we will see volatility subside.”

Aussie-funded emerging market carry trades have returned an average of 3.1% since the Reserve Bank of Australia slowed the pace of its hikes on Oct. 4. This is almost double the returns from dollar-based trading in the run-up to the last inflation. report even though there were brief bursts in risk sentiment which restrained the US currency.

Developing country currencies are on course for their worst annual performance against the US dollar in seven years, while the Aussie is heading for its worst year since 2018. The tandem losses have helped maintain the gauge of Benchmark stable local exchange rates against the Australian Dollar.

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The policy divergence between the RBA and the Fed helped reverse a negative correlation between emerging market currencies and the Aussie. The relationship, based on a 30-day rolling basis, hit its highest level since Sept. 20. This makes Australian currency-funded carry trades a less risky proposition.

“The cost of shorting US dollars is high and is expected to rise further,” said Alvin Tan, head of Asian currency strategy at Royal Bank of Canada in Singapore. On the other hand, “the recent pivot in the RBA is likely to skew the Aussie-currency differentials in favor of the AUD.”

Amazing peers

The Australian dollar is generally not favored when it comes to financing carry trades. It is one of the most popular targets for arbitrage traders, especially those shorting the yen. The Japanese currency, and other low-yielding currencies like the Euro, are the preferred alternatives to the dollar in a normal world. But now, the flux in the global currency and bond markets is upending that norm.

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Yen weakness may have already peaked as traders fear increased intervention from authorities to support the currency, while the euro is expected to strengthen amid hawkish rhetoric from the European Central Bank. The British pound, too, is now shunned by traders.

“The pound has become a fragile currency plagued by outflows and declining confidence,” said Giuseppe Sette, chairman and co-founder of Toggle AI. “This makes it a better candidate for financing carry trades in emerging markets. Borrowing in pounds might not prove so easy, however.

Yet the allure of alternatives, including the Aussie, could evaporate at any time, should the dollar extend its decline. Four successive months of moderating inflation in the world’s largest economy have reduced pressure on the Fed and rekindled a rally in riskier assets.

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Therefore, the Aussie cannot replace the US dollar but act as a diversification option on the funding leg of carry trades. RBC’s Tan suggests Australian dollar-funded carry trades should be used as a hedge against volatility in a traditional portfolio. Australian emerging market currency pairs have low liquidity, and investors should be on the lookout for hurdles in exit positions.

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—With help from Colleen Goko.