Analysts are cautious on intra-EMU carry trades because spreads are too tight. The low carry, or "skinny carry," provides an insufficient cushion against external risk-off events, which can wipe out months of gains. The advice is to await wider spreads before re-entering these crowded positions.
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Despite the unusual dynamics in G7 volatility, the strategist warns that for crowded high-yield emerging market carry trades, the old rules still apply. If the consensus trade is upended for any reason, EM volatility and risk reversals are expected to 'blow up,' making protective options a prudent hedging strategy.
A strategic divergence exists in EM corporate credit. Mandate-bound real money funds feel compelled to stay invested due to a lack of near-term negative catalysts, while more flexible hedge funds are actively taking short positions, betting that historically tight spreads will inevitably widen over the next 6-12 months.
While still profitable, FX carry trades have become more cyclical and less of a diversifier. They now exhibit a high correlation (~0.5 beta) with the S&P 500 and offer significantly lower yields (7% vs. 11-12% previously), increasing their risk profile in a potential market downturn.
The success of the current EM FX carry trade isn't driven by wide interest rate differentials, which are not historically high. Instead, the strategy is performing well because a resilient global growth environment is suppressing currency volatility, making it profitable to hold high-yielding currencies against low-yielders.
A popular investment strategy involves borrowing cheap Japanese Yen to buy higher-yielding US assets. This creates a hidden vulnerability. A sudden strengthening of the Yen would force these investors into a mass, simultaneous fire-sale of their US assets to cover their loans, triggering a systemic liquidity crisis.
Improving risk-adjusted carry in intra-EMU spreads is deceptive, driven by falling volatility, not higher returns. This creates a 'carry trap' where a small one-standard-deviation widening can erase one to two months of gains, highlighting the risk in currently crowded positions.
The market believes the Fed is more likely to ease on weak data than tighten on strong data. This perceived asymmetry in its reaction function effectively cuts off the 'negative tail risk' for global growth, making high-yielding emerging market carry trades a particularly favorable strategy in the current environment.
While broad emerging market currency indices appear to have stalled, this view is misleading. A deeper look reveals that the "carry theme"—investing in high-yielding currencies funded by low-yielding ones—has fully recovered and continues to perform very strongly, highlighting significant underlying dispersion and opportunity.
With credit spreads already tight, their potential upside is limited while their downside is significant in a recession scare, offering poor convexity. Goldman Sachs advises that a better late-cycle strategy is to move up the risk curve via equities, which offer more upside potential, rather than through credit investments.
In a market where spreads are tight and technicals prevent sustained sell-offs, making large directional bets is a poor strategy. The best approach is to stay close to benchmarks in terms of overall risk and allocate the risk budget to identifying specific winners and losers through deep, fundamental credit analysis.
