8/2/15: Carry Trades Returns: More Pressure for Ruble & CBR

Carry trades involve borrowing in one currency at lower interest rates (say in Euro or Japanese Yen) and 'carrying' borrowed funds into investment or lending in another currency, bearing higher interest rates (e.g. into Australia or New Zealand, or Russia or Brazil). The risk involved in such trades is that while you hold carry asset (loan to, say, an Australian company), the currency underlying this asset (in this case AUD) devalues against the currency you borrowed in (e.g. Yen). In this case, your returns in AUD converted into Yen (funds available for the repayment of the loan) become smaller.

With this in mind, carry trades represent significant risks for the recipient economies: if exchange rates move in the direction of devaluing host economy currency, there can be fast unwinding of the carry trades and capital outflow from the host economy.

Now, let's define, per BIS, the Carry-to-Risk Ratio as "the attractiveness of carry trades" measured by "the ...risk-adjusted profitability of a carry trade position [e.g. the one-month interest rate differential]... divided by the implied volatility of one-month at-the-money exchange rate options".  In simple terms, this ratio measures risk-adjusted returns to carry trades - the higher the ratio, the higher the implied risk-adjusted returns.

Here is a BIS chart mapping the risk-adjusted ratios for carry trades for six major carry trade targets:

Massive devaluation of the Russian Ruble means that carry trades into Russia (borrowing, say in low interest rate euros and buying Russian assets) have fallen off the cliff in terms of expected risk-adjusted returns. There are couple of things this chart suggests:

1. Dramatically higher interest rates in Russia under the CBR policy are not enough to compensate for the decline in Ruble valuations;
2. Forward expectations are consistent with two things: Ruble devaluing further and Russian interest rates declining from their current levels.

Still, three countries with massive asset bubbles: New Zealand, Australia and Mexico are all suffering from far worse risk-adjusted carry trade performance expectations than Russia.

The Russian performance above pretty much confirms my expectations for continued weakness in Ruble and more accommodative gradual re-positioning of the CBR.

16/1/2015: S&P Capital IQ Global Sovereign Debt Report: Q4 2014

S&P Capital IQ’s Global Sovereign Debt Report is out for Q4 2014, with some interesting, albeit already known trends. Still, a good summary.

Per S&P Capital IQ: "The dramatic fall in oil prices dominated the news in Q4 2014, affecting the credit default swaps (CDS) and bond spreads of major oil producing sovereigns which have a dependence on oil revenues. Venezuela, Russia, Ukraine, Kazakhstan and Nigeria all widened as the price of oil plummeted over 40%. Separately, Greece also saw a major deterioration in CDS levels as it faces a possible early election."

And "Globally, CDS spreads widened 16%."

No surprises, as I said, but the 16% rise globally is quite telling, especially given CDS and bond swaps for the advanced economies have been largely on a downward trend. The result is: commodities slump and dollar appreciation are hitting emerging markets hard. Not just Russia and Ukraine, but across the board.

Some big moves on the upside of risks:

• "Venezuela remains at the top of the table of the most risky sovereign credits following Argentina’s default in Q3 2014, resulting in its removal from the report, with spreads widening 169% and the 5Y CDS implied cumulative default probability (CPD) moving from 66% to 89%." 
• The only major risk source, unrelated to commodities prices is Greece where CDS spreads "widened to 1281bps - an election as early as January could see a change of government and fears over a possible exit from the Eurozone have affected CDS prices." 
• "Russia enters the top 10 most risky table as CDS spreads widened around 90% following the fall in oil price which is adding more pressure to an economy already subject to continued economic sanctions." 
• "Ukraine CDS spreads also widened by 90%." 
• "CDS quoting for Nigeria remained extremely low throughout the last quarter of 2014. Bond Z-Spreads widened 150bps for the Bonds maturing in January 2021 and July 2023 but remained very active." 

Venezuela and Ukraine are clear 'leaders' in terms of risks - two candidates for default next.

Other top-10 are charted over time below:

Again, per S&P Capital IQ:

• "The CDS market now implies an 11% probability (down from 34% in Q3 2014) that Venezuela will meet all its debt obligations over the next 5 years, as oil prices dropped 40% in Q4 2014." 
• "Russia and Ukraine CDS spreads widened 90% during Q4 2014. The Russia CDS curve also inverted this quarter with the 1Y CDS level higher than the 5Y. Curve inversion occurs when investors become concerned about a potential ‘jump to default’ and buy short dated as opposed to 5Y protection." This, of course, is tied to the risks relating to bonds redemptions due in H1 2015, which are peaking in the first 6 months of the year, followed by still substantial call on redemptions in H2 (some details here: http://trueeconomics.blogspot.ie/2014/11/24112014-external-debt-maturity-profile.html). As readers of the blog know, I have been tracking Russian and Ukrainian CDS for some time, especially during the peak of the Ruble crisis last month - you can see some comparatives in a more dynamic setting here: http://trueeconomics.blogspot.ie/2014/12/16122014-surreal-takes-hold-of-kiev-and.html and in precedent links, by searching the blog for "CDS".
• "Greece, which restructured debt in March 2012, returned to the debt markets this year. CDS spreads widened to 1281bps and the 4.75Y April 2019 Bonds, which were issued with a yield of 4.95%, now trade with a yield of over 10%, according to S&P Capital IQ Bond Quotes." 

By percentage widening, the picture is much the same:

So all together - a rather unhappy picture in the emerging markets - a knock on effect of oil prices collapse, decline across all major commodities prices, dollar appreciation and the risk of higher US interest rates (the last two factors weighing heavily on the risk of USD carry trades unwinding) - all are having significant adverse effect across all EMs. Russia is facing added pressures from the sanctions, but even absent these things would be pretty tough.


Note 1: latest pressure on Ukraine is from the risk of Russia potentially calling in USD3 billion loan extended in December 2013. Kiev has now breached loan covenants and as it expects to receive EUR1.8 billion worth of EU loans next, Moscow can call in the loans. The added driver here (in addition to Moscow actually needing all cash it can get) is the risk that George Soros is trying to get his own holdings of Ukrainian debt prioritised for repayment. These holdings have been a persistent rumour in the media as Soros engaged in a massive, active and quite open campaign to convince Western governments of the need to pump billions into the Ukrainian economy. Still, all major media outlets are providing Soros with a ready platform to advance his views, without questioning or reporting his potential conflicts of interest. 

Note 2: Not being George Soros, I should probably disclose that I hold zero exposures (short or long) to either Ukrainian or Russian debt. My currency exposure to Hrivna is nil, to Ruble is RUB3,550 (to cover taxi fare from airport to the city centre on my next trip). Despite all these differences with Mr Soros, I agree that Ukraine needs much more significant aid for rebuilding and investment. Only I would restrict its terms of use not to repay billionaires' and oligarchs' debts but to provide real investment in competitive and non-corrupt enterprises.

Economics 28/11/2009: What if... Carry Trades bite the dust in Dubai

Carry trades, Dubai and the direction of the dollar:

Dubai's impending collapse shows that the epicenter of 'Development on Drugs' model implosion is now finally shifting from the US into Middle East and is risking new wave of contagion into Europe. Most of Dubai development has been financed by petrodollars (domestic and inter-regional), but also via carry trades from Europe (intraregional) with Euro area banks dominating the entire Emirate's landscape in foreign banking. This is bound to have long-reaching impact, with as far on-shore as Irish Nama potentially being possibly saddled with loans cross-linked to Dubai property. Bank of Ireland took part in a $5.5 billion (€3.7bn) syndicated loan facility to Dubai World in June 2008, according to stockbroker Davy. Per report in Irish Times today: "The firm said its initial participation in the facility was $93 million (€62 million) but it is understood that the bank’s debt currently stands at about €50 million."

Am I the only one who noticed that Irish investors, semi-states - e.g Aer Lingus, corporates - see here, even Enterprise Ireland succumbed to Dubai's lure: here - have financed the peak of this bubble?

Oh, and is Nama going to end up holding any of this (more here)? Nama folks are saying they know nothing about the Bad Bank taking on Dubai-related loans... Sure... they would know! And what about cross-linked loans? Developers with dual exposures?


So what does Dubai debacle mean globally?

Start with oil: the only way the Emirates are going to escape a meltdown (with domino effect spreading from Dubai to Abu and so on) is by turning on oil taps. An added incentive here is that while autocratic rulers of the Emirates would not blink twice before saddling Western investors with all debts, the structure of Islamic finance used in Dubai developments implies that although junior debt holders have no explicit guarantees on their debt, Emirates simply will not be able to stomach defaulting on Islamic loans. Oil prices will be under pressure for a long period of time before Dubai's debt mountain is cut to size and this will give support to the weakened dollar on asset demand side of the dollarised carry trades involving commodities.

Bigger question is whether Dubai events might trigger the unwinding of the carry trades. This, of course, depends on the value of UAE currency and the main currency pairs used in the region. In my view, devaluation of massive proportions will be required in the short run, putting pressure on the Euro and, again, aiding the dollar.

Another force acting here will be investor confidence. If Dubai served as an island for divestment out of dollar assets in the region, this island is now fully submerged under financial tsunami. Treasuries are to firm up and dollar alongside these. Ditto for gold.

On a separate note, another net positive (longer term) for the dollar is China. President Obama's visit played out as a play of avoiding the issues of yuan, and yielded absolutely no commitment to revalue Chinese currency. This, strangely enough, implies that once revaluation does take place, it will be much more pronounced and abrupt than if the Chinese authorities were to offer President Obama some concessions this month. Here is why. Absent Chinese commitment to play cooperative game with the US on currency front, Obama Administration will let Europeans put pressure on China through bilateral channels and G20. Europe cannot afford to hold the bag in the global devaluation game as it is exports oriented economy. Developing and emerging economies will fight by imposing capital controls, but EU will have to bring this battle to Chinese shores. Thus, in the long run, the stage is now set for overshooting revaluation of the yuan well above its long-term target and firming up of the dollar.

In the medium term, all this uncertainty about the ultimate rebalancing of the FX markets will be pushing on gold. This is likely to coincide with the emerging markets shocker from Dubai and capital controls impositions, further enhancing demand for the store of value assets such as precious metals. Not to be sensationalist, but if we are at the starting point of Wave II of the crisis (even if it is only a smaller aftermath to the 2008 one), is gold at $1,500-$1,700 oz a possibility?

Just asking...