The case for emerging market currencies
Warning: parts of this article (in particular the currency options section) may be for more advanced readers/traders
While most of us have focused for good reasons (liquidity, transparency) on the major currency pairs such as EUR/USD or USD/JPY, there’s a great opportunity waiting out there for those willing to take a chance with less well-known currencies such as the Brazilian Real (BRL) or the South Korean Won (KRW). As always we need to examine the forces moving such currencies. As you will see, there are many positive aspects of emerging markets (EM) and their respective currencies.
First, let us consider the case against developed countries (reasons to be short these currencies).
- The debt of the developed countries is huge, and will hang over their economies for a very long time. The aggregate G7 debt is 10% of GDP.
- They will emerge more slowly from recession, and will tend to keep a tighter lid on interest rates, keeping monetary policy loose. In 2010, the forecast GDP growth in the US is 2.7%, in Japan, in the UK and EZ it’s 1.5%, and in Australia it’s 3.3%. By contrast, the forecast GDP growth in China is 9.8%, India and Korea 7.8%, Brazil 5%, and Singapore 6.5%
- Strong capital outflows- investors seeking return. The growing popularity of ETFs focused on Emerging Markets is a good example of this.
- Commodity consumption, leading to larger current account deficits
- Demographics – ageing, shrinking populations (especially Japan, but EZ and the US, too)
EM countries, on the other hand,
- Offer the best carry trade opportunities. For example, today the Brazilian Real is at 8.75%, the South African Rand is at 7%, and the Turkish Lira is at 6.75%
- Their economies are poised for much stronger growth. Emerging Asia is forecast to grow nearly 8% in 2010. Some think that in the next 5-10 years, 2 of the 4 largest economies will be EMs.
- Strong capital inflows (aka Foreign Direct Investment or FDI) seeking return
- Commodity production and export, leading to current account surpluses
- Demographics- younger, growing populations with greater fractions of contributing people.
Currencies benefit from high growth (because rising GDP & CPI drives central bank interest rates higher, attracting carry traders) and capital inflows (because local investment requires local currencies- forcing the local currency to be bought, which drives it up).
These are fundamental forces, and while in the long run will prevail, you must keep in mind that in the short term, sentiments sometimes counter these forces.
So obviously, the idea is to be long strong EM vs weak developed country. For example, long BRL/GBP, or long KRW/$.
What are the risks? There’s always the chance that the nascent recover will falter, be a double dip, or some other structure that puts these long term trends on hold (they are inescapable in the long run). Emerging Markets sometimes experience currency crises (lack of foreign reserves, high current account deficits), resulting in monetary controls, intervention and other tools which can temporarily hurt a currency.
So we need to ask how best to trade the EM currencies while managing risk? I have three example methodologies.
1) First, simply long the spot, with low leverage. This is what most folks do, and will benefit from the long term appreciation we expect, along with excellent carry. Pending dramatic movements are almost always signaled by market watchers like the IMF or World Bank. A devaluation should never take you by surprise. Here’s an example of the ZAR (South African Rand) appreciating over a long period of time due to fundamentals (Gold, other commodity appreciation)
2) Second- long the spot with some insurance. To protect against a devaluation or depreciation, put on what is called a collar. This is an option structure often used by import/export companies to protect against currency risk in a forward. The most basic structure is long an out-of- the- money put (protect the downside), paid for by a short out-of-the-money call. While this limits the upside, you are protected the downside, and collect the carry. Here’s a P&L example. Protected by the put, you can leverage up the spot to get high net carry, knowing your downside is limited.
3) My personal favorite, simple long-dated (1 yr+) option spreads. This is the favored methodology of such incredible money managers as Jim Leitner, Christian Siva-Jothy and others. It provides excellent risk management, strong upsides, and limited loss. Here’s an example P&L of a bullish spread (long call @ 90, short call @ 95, short put @ 80) I just did last week on the $/JPY. It created a maximum 4:1 payoff.
So in conclusion, I believe than the EMs are going to offer the best returns over the longer term, based on inescapable trends. While the risk is there, methods and tools exist to mitigate those risks.
Paul Stafford writes a weekly Currency Briefing, reviewing the fundamentals moving the major currencies. To download a sample briefing, or to subscribe, please visit www.4xtradertools.com
