Beware the Negative Feedback Loop in Emerging Market Currencies

Emerging markets are already under fire. But if history serves as a lesson, it could still get much worse.

The more interconnected the global financial system has become, the fewer new ideas there are for investors to explore and exploit. This has the effect of leading herds of investors into the same global macro trades. And the end game is usually rather predictable.

You see a positive feedback loop on the way in: Buyers bid up prices, higher prices entice more buyers, who further bid up prices.

This quickly turnrns into a negative feedback loop on the way out: Something changes and spooks buyers, they sell, pushing down prices, which spooks other investors, who then sell in panic… pushing prices down even further.

We’ve seen this before in the yen carry trade.

In the 1990s, investors could borrow Japanese yen at very low rates. They’d then invest those yen in higher-yielding currencies, like the U.S. dollar, earnrning throughout the year the difference in the two interest rates. For many years, this netted investors an easy 4% to 5%, before leverage.

Naturally, the trade became very popular with a plethora of yen sellers, and just as many U.S. dollar buyers.

Of course, like all good things, it didn’t last.

As prevailing interest rate trends reversed, investors in the carry trade got stuck holding the bag and took massive losses.

The yen carry trade has long ended. But new ones emerge from time to time. The latest? Emerging market currencies.

Citi published a great graphic that shows the predicament emerging market policymakers now face as their currencies slide lower in value. Here it is:

Keep in mind, these emerging market currencies yield far more than the U.S. dollar (which isn’t hard with the Fed pinning rates to the floor). That’s led many investors into new emerging market carry trades, where they borrow U.S. dollars and reinvest in foreign currencies, earnrning a spread of:

  • 14% on the Indonesian rupiah;
  • 8% on the Turkish lire, Indian rupee and Brazilian real; and
  • 6% on the South African rand and Russian ruble.

But the same buyers who poured into these emerging market currencies are now quickly rushing OUT.

As the Citi graphic above shows, this leaves policymakers with no good options. They could:

  1. Raise interest rates (attracting more carry trade buyers), but that would slow or choke economic growth.
  2. Buy their own currencies in bulk (thwarting price declines), but they’d deplete their currency reserves.
  3. Do nothing (allowing the free market to figure it out), which would likely put emerging market currencies into a free fall.

This is truly one of those rock-and-a-hard-place scenarios.

Bottom line: a very bullish outlook for the dollar (which we’ve been saying for years now).

For specifics on how to play this trend, consider joining Boom & Bust.

Adam O’Dell

Using his perfect blend of technical and fundamental analysis, Adam uncovers investment opportunities that return the maximum profit with minimum risk.