Deutsche Bank Markets Research Emerging Markets Special Report Economics Foreign Exchange FX Spot FX Volatility Date 23 January 2018 The curious case of EM FX Carry _Deutsche Bank Securities Inc. DISCLOSURES AND ANALYST CERTIFICATIONS ARE LOCATED IN APPENDIX 1. MCI (P) 083/04/2017. Drausio Giacomelli Strategist (+1) 212 250-7355 drausio.giacomellidb.com Jundong Zhang Research Associate (+44) 20 754-72056 jundong-a.zhangdb.com Gautam Kalani, Ph.D. Strategist (+44) 20 754-57066 gautam.kalanidb.com EM assets and FX in particular have long been considered analogous to the “carry trade”. Although carry is still an important component of total performance, the global financial crisis (GFC) and QE have been associated with a marked change in the importance and nature of carry contributions to total returns. Not only carry has become less important a contributor, but rather than amplifying the benefit of USD weakness it has actually attenuated this boost. As we have discussed in several recent pieces, the USD has been the dominant factor, and as we discuss later in the report country specifics have also grown in importance. Distributed on: 23/01/2018 07:00:00 GMT7T2se3r0Ot6kwoPa23 January 2018 Special Report: The curious case of EM FX Carry Page 2 Deutsche Bank Securities Inc. The sliding doors of EM FX performance EM assets and FX in particular have long been considered analogous to the “carry trade”. Although carry is still an important component of total performance, the global financial crisis (GFC) and QE have been associated with a marked change in the importance and nature of carry contributions to total returns. Not only carry has become less important a contributor, but rather than amplifying the benefit of USD weakness it has actually attenuated this boost. As we have discussed in several recent pieces, the USD has been the dominant factor, and as we discuss later in the report country specifics have also grown in importance. The importance of the USD EM FX was certainly not a “carry trade” in 2017 despite record-low volatility and peaking global liquidity usually the sweet-spot for search for yield strategies. The (monthly rebalanced) FX “carry trade” earned only -0.3%1 over the whole year (see the chart below), which compares with an annual return of nearly 9% for simply buying a fixed trade-weighted basket of EM currencies vs. the USD. Instead, 2017 was the year of the directional trade, with the USD dictating the direction and carry providing poor signaling for portfolio selection. Consequently carry baskets lagged only recovering some ground late in the year as the chart below shows. Poor carry performance despite ideal backdrop Source: DB Research, Bloomberg Finance LP Even if we assess a longer time horizon, for example the last decade, carry performance has been lackluster (chart below) carry performed well between 2003 and 2007, but returns stalled after that. Further, the underperformance of carry baskets cannot be explained simply by the numerous shocks that have occurred over the past decade2. Even when we test and adjust the 1 Our carry trade strategy is as follows: rank 29 currencies (EM+DM) according to their ex-ante carry (rate differentials) every month; long the currencies with 4 highest carry with equal weights (high carry basket) and short 4 lowest carry currencies. All the analysis and numbers in this piece exclude transaction costs, unless stated otherwise 2 In “EM carry trade: easier said than done” we explore the impact of drawdowns on carry trades identifying USD rallies and the taper tantrum as major shocks. strategy so that carry baskets are unwound in risk-off periods, the relative performance of carry vs. simply holding broad EM FX baskets improves only mildly3. Therefore, more than “risk-on and risk-off” swings, there is a more meaningful underlying drivers of this underperformance of recent years. EM FX: less and less a carry date Source: DB Research, Bloomberg Finance LP Reinterpreting sources of value in EM FX Lower rates in EM and shrinking interest rate differentials vs. DM are taking a toll on the contributions of the carry factor to EM FX returns. As the chart below shows, carry was a large contributor pre-GFC, but it has lagged since, especially as the expansion of QE “lifted all boats” in risky markets reducing differentiation. Accordingly, carry may increase in importance as a factor driving EM FX returns again once QE is unwound, especially if EM rates increase over time as well. But this may still take several years. Shrinking carry contribution post-GFC Source: DB Research, Bloomberg Finance LP 3 We apply a simple “trading strategy”: when GFSI 0.7 in the currently month, we exit carry trade only for the next month and resume carry trade as of the month after next m