As I noted in November 2013, there's more to emerging markets than free money flowing from a funding-currency country. You need attractive interest rates in the receiving market to keep the carry trade open. Part of the reason for the rebound in the Latin American markets discussed last month has been higher interest rates in Brazil.
But to complicate matters, as if I ever would do such a dastardly deed, poor relative stock market returns can outweigh simple carry trade inducements and lead to a weaker currency. The ideal combination for an emerging market these days is short-term interest rates high enough to maintain an open carry trade, but not high enough to choke off the local bourse.
Peso and Performance
Let's revisit a July 2013 analysis of the link between the dollar carry trade into the peso and the relative performance of Mexican equities.
Prior to 2006 and the combined effects of much higher oil export earnings and worker remittances, the carry return into the peso reflected the effects of Mexico's much higher short-term interest rates. Yield hogs could send their funds south of the border, park them in short-term deposits, and pray the peso wouldn't devalue by more than the cumulative interest-rate spread gain.
After 2006 -- and especially after the financial crisis led to a global downward compression of interest rates -- the carry return increasingly reflected relative stock market performance; indeed, relative performance started to lead the carry return by three months on average. If Mexican equities performed strongly, yield hogs' performance-chasing cousins (let's call them performance pigs for lack of a better term) started buying Mexican assets through funds such as the iShares MSCI Mexico Capped ETF (NYSEARCA:EWW) or the ProShares Ultra MSCI Mexico dos-por-uno ETF (NYSEARCA:UMX).
This leading relationship is making the carry trade into the peso vulnerable. It has been able to levitate over the past year on the basis of its historically narrow but relatively attractive short-term interest rate gap, but all it will take for the peso to tumble is an interest rate scare here in the US or one of those periodic emerging market panics we see every now and then. The current level of relative stock market performance implies the carry return is overvalued on the order of 14.25%.
The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.
Copyright 2011 Minyanville Media, Inc. All Rights Reserved.