‘Carry trade’ may batter peso further

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Investor reactions to US, Japan factors could drive currency lower vs dollar

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THE decline of the peso against the US dollar, already driven by the strength of the US unit and rising OFW remittances ahead of the holiday season, could accelerate on the impact of “carry trade” on the local market, a risk that has grown with the prospects of higher US interest rates and yen devaluation.

Carry trade is a common foreign exchange trading strategy that involves borrowing one currency to invest in a different currency, with the goal of profiting from the difference in interest rates between the two.

Reports by major business news outlets since midsummer have repeatedly identified the Philippines —along with Thailand and Indonesia—as attractive destinations for the carry trade, thanks to their relatively stable currencies and higher interest rates. A report by Forbes in early September estimated the total value of the carry trade in emerging markets to be at least $2 trillion annually, with perhaps as much as a third of that finding its way to Southeast Asian markets, including the Philippines.

“It [the carry trade]is a big part of the peso market right now,” an analyst in the Treasury department of a major local bank, one of the bigger players in the local currency market, agreed. “And it’s going to last until things normalize in the US economy with the expected rise in interest rates there.”

“The Philippines is a good carry trade destination, because the BSP [Bangko Sentral ng Pilipinas] is doing an excellent job of supporting the peso and keeping market volatility in check,” the analyst added.

How the carry trade works
The trader profits, or has a “positive carry” because the interest earned on the security purchased with the borrowed and then converted currency (30- or 90-day T-bills are popular for carry trades) will be greater than the interest due on the original loan.

Profits will be even greater if the original currency weakens with respect to the target currency or the target currency strengthens, especially if the trades are leveraged, which they often are. Large, established traders such as banks are often able to leverage their trades at a ratio of up to 300 to 1, so a single carry trade transaction on that scale can cause a big move in both currency and security prices.

Traders will often spread the risk by distributing the original currency among a basket of target currencies, or borrowing target currency from big offshore holders (as opposed to converting it in the target market) at lower interest rates. Even so, the strategy is not for the faint of heart: If the target currency loses value or if bond or T-bill yields decrease—such as might happen if interest rates are reduced—a “negative carry” can quickly result.

At least as far as the Philippines and other regional currencies are concerned, that so far does not seem to be the case. Data compiled by Commonwealth Bank of Australia in September indicated carry traders were earning an average of about 1 to 1.5 percent on transactions—the net of borrowing on offshore currency forwards at 0.4 to 0.8 percent interest and collecting returns of about 1.49 percent on Philippine three-month T-bills. Data published just last week by Bloomberg analysts, who focused on Singapore, showed that the carry trade in Singapore dollars has earned about 2.2 percent since the end of June against a basket of the peso, the Thai baht, the Indonesia rupiah, and the Malaysian ringgit, versus a 1.7 percent loss against the US dollar.

Good news, bad news
While the carry trade poses a number of risks to currency valuations and the larger economy, it is not inherently bad. It represents a significant level of demand for the peso, which in turn helps to insulate the currency’s value to some degree against the effects of inflation and money flows in other parts of the economy like the stock market.

Another factor which is likely to come into play over the next few months is the impact of the Bank of Japan’s version of quantitative easing, which is primarily intended to push down the value of the yen. Even though the announcement of the loosening of monetary policy by the BOJ at the beginning of this month caused a dip in the peso’s value – largely due to the US dollar picking up strength on the same news – it is still potentially good news in one sense because the BOJ action will make a large amount of fresh cash available, some of which find its way into the carry trade.

The bad news is the prospect that the “considerable time” US Fed chief Janet Yellen said Fed interest rates would be maintained at near-zero levels appears to be drawing to an end, with a growing consensus that a rate hike is in the offing as early as next quarter.

That, along with a strong dollar and weakening peso, could ‘unwind,’ or reverse the carry trade very quickly as investors shift attention to the US and Japan.

BSP monitoring
Although the BSP typically does not discuss the extent to which it intervenes to manage the currency market, the central bank did acknowledge the potential for increasing volatility, but is taking a broader view towards supporting the peso’s value.

“The BSP recognizes that maintaining strong macro-economic fundamentals in a stable environment could tend to influence carry trade-related flows,” the BSP explained in a statement. “With volatility possibly continuing in the coming months in light of the potential normalization of US monetary policy and the consequent re-pricing of risks in the financial markets and capital flow reversal in emerging markets, the market is expected to focus on the Philippines’ strong macro-economic fundamentals, and the BSP is certainly firmly committed to providing a stable economic environment. The BSP will therefore continue to closely monitor developments in key financial markets with a view to ensuring orderly market conditions.”

At least to this point, the BSP’s oversight seems to have worked to at least slow the pace of any reversal of the carry trade. “To some extent the carry trade unwinding has already happened, just on the anticipation of a Fed interest rate increase,” the local bank analyst pointed out. “We think that’s what the peso’s move from the 43 level to 45 to the dollar actually was.”

Data supplied by the BSP indicates that through the close of trade on November 17, peso volatility and depreciation were trailing the regional averages for both. Most analysts, however, are bracing themselves for further declines, albeit controlled ones. “We are looking at the peso going to the 46 level once the Fed finally does raise rates, also taking in account the developments in Japan, which are going to support their exporters and hurt our importers,” the bank analyst added. (see related story, “Private analysts forecast: Peso to hit P46: $1”)

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