High-yielding currencies back in form

HIGH-YIELDING emerging market currencies enjoyed a startling return to form in September and analysts say the outlook for the final quarter also looks positive, though not without risk.

June to August proved a difficult period for most of these currencies as a vicious sell-off in global fixed income markets triggered a bout of risk aversion. Emerging markets are generally seen as higher-risk destinations. However, with bond markets calmer, risk appetite has gradually returned and, with US interest rates low, investors are looking again at high-return emerging market currencies.

The South African rand , Turkish lira, Brazilian real and Hungarian forint have led the way up over the past month.

“Some of the conditions that supported the great carry trade of the first half are back in place,” analysts at Bank of America said in a research note.

“Investors have high cash levels by the end of September, having reduced substantially their asset market exposure in the summer volatility. With coupons and amortisations boosting that still further in September and October, investors are putting that money to work.”

Other analysts say this year’s high-yield bull run is ultimately founded on low US interest rates and as long as they remain, the rally should be well supported.

“By far the most important factor behind this rally is that US interest rates are still negative in real terms,” said David Lubin, senior emerging markets analyst at HSBC. “A rise in US rates could be pretty fatal, but we’re not forecasting that to happen anytime soon, so the rally might be sustainable for quite some time,” he added.

Low US rates not only cause investors to seek higher returns elsewhere, they also encourage increased capital flows by making it cheaper to borrow.

The rand is up 7.6% against the dollar from lows hit earlier in September, while the lira hit 16-month highs this week, resuming rallies that have seen both rise around 20% against the greenback over the year to date. The real is up 2.85% this month and the forint has jumped more than 8%. Another major reason for the resurgence of emerging market high-yielders has been broad-based dollar weakness.

Dollar losses accelerated dramatically, particularly against the Japanese yen, after the recent Group of Seven meeting in Dubai called for more flexible currency policies.

Further dollar weakness would probably mean more gains for emerging market high-yielders, but that scenario is not without risks.

“A dollar in freefall is not good for anyone because it risks major financial market instability. The dollar outlook is very important and needs to be watched carefully,” said Callum Henderson, emerging markets analyst at Bank of America.

Lubin at HSBC said that while the rally looked well set in the near-term, the seeds of its own end had already been sown.

“As a currency strengthens it puts downward pressure on interest rates by lowering inflationary expectations and it works to increase the current account deficit,” he said.

A stronger currency makes a country’s exports more expensive and imports cheaper, so external balances tend to deteriorate. While the rewards for holding the currency decline in terms of falling interest rates, the risks increase in the form of bigger deficits.

“At this stage, the mechanism by which a virtuous circle becomes a vicious one is starting to become visible, especially in Turkey’s case, reducing the willingness at the margin of people to be long the currency,” said Lubin.

Turkey’s Economy Minister Ali Babacan said the country’s current account deficit was likely to rise to 3% of GDP by the end of the year, from 1% in 2002.