USD carry trade threat to markets

KUALA LUMPUR: Emerging market equity funds saw renewed interest last week spurred by a weak dollar and low US lending rates, after experiencing their first outflows since the third week of July in the previous week.

Emerging Market Equity Funds, Global Equity, Commodity Sector, Energy Sector and Global Bond Funds all posted strong inflows during the week ended Nov 11, according to data from Emerging Portfolio Fund Research, Inc (EPFR).

Flows into the diversified Global Emerging Markets (GEM) Equity Funds totalled US$1.48 billion (RM4.99 billion) while Asia ex-Japan Equity Funds absorbed US$626 million.

“In addition to being seen as a haven from dollar weakness, emerging markets benefited during the first full week of November from some robust Chinese macroeconomic data showing GDP growth on track to exceed 10% during the fourth quarter of 2009 (4Q09),” said the funds flow and asset allocation data provider in its report last Friday.

This contrasts with the week ended Nov 4, when GEM Equity Funds experienced US$539 million in outflows.

On the home front, Jupiter Securities head of research Pong Teng Siew said foreign funds using the dollar carry trade had been playing a part in the Malaysian market as the rally in the FTSE Bursa Malaysia KLCI had been correlating closely to dollar weakness.

The dollar index that measures the US dollar against six major currencies is about 7.3% down year to date at 75.389 as at press time. The US Federal Reserve had cut its target overnight rate to a low 0.25% last December and repeated its pledge to keep the rate near zero for “an extended” period, according to a Bloomberg report last Friday.

Pong is concerned about this and said that if there was a sudden strengthening of the dollar, carry trades would unwind causing a harsh outflow from emerging markets, including Malaysia.

In a report on Nov 9, Macquarie Equities Research said it was clear that stretched valuations had been a consequence of the US dollar carry trade, which had reflated Asian markets in general and indirectly supported Malaysian valuations.

“By its nature, a carry trade is a momentum trade. As markets rise, hedge investors increase leverage and bet on momentum. Thus, a carry trade will not be unwound until the momentum turns. Thus a trigger is needed to turn the tide,” it said.

It said from the yen carry trade experience, which was only fully unwound in 3Q08 when Lehman Brothers was allowed to go under, weakness in the carry trade preceded increases in interest rate.

“It is hard to pinpoint events that will eventually trigger a turning point, However, what we can do is monitor fund flows and attempt to imply the right timing from there,” Macquarie said.

It said there had been large inflows almost matching 2007 levels, into Asia and GEM equity markets in 2009, but of late, flows into Asian equities had tapered off, while flows into GEM continued to be strong.

“Because valuations are already so stretched, we reckon that the momentum trades could turn sooner rather than later, and certainly before 2H10 when we first expect US dollar interest rates to start rising,” it said.

Meanwhile, Pong said foreign funds that had come into the Malaysian market over the past week were selling out last Thursday and Friday, but the FBM KLCI did not fall much as the exiting funds were selling their holdings to other funds which were entering the Malaysian market. “This means that the climb is on hold for the time being,” he said.

Market observers said while the dollar carry trade was playing a part in the local market, the US dollar was not expected to strengthen suddenly, due to the weak economic indicators emerging from the US.

This is despite US Treasury Secretary Timothy Geithner’s statement last Wednesday that he believed it was important for the US to maintain a strong currency.

“He may want the dollar to strengthen but if the US economy is not doing well, how will it happen?” said an economist, adding that the weaker dollar and carry trades were likely to continue well into next year.

As for foreign participation in the Malaysian market, several people in the local investment community when contacted said it was still at a level lower than it had been prior to the economic crisis. One said foreign participation could be “quite limited” as local funds may also be trading through foreign brokers.

According to one head of research, foreign trading participation has been rising for the past three months. Bursa Malaysia statistics on trading participation showed that in October, foreign institutional and foreign retail trading made up 24.86% and 0.57% of the total RM26.2 billion in value traded.

Meanwhile, despite the focus on the weakness of the dollar, in the week to Nov 11, flows into US Equity Funds hit a 47-week high as investors were attracted to its stocks in light of recent earnings reports and expectations that domestic interest rates will stay at current levels well into next year.

EPFR reported that Energy Sector Funds enjoyed their best week since early 4Q08 and year-to-date flows into Commodity Sector Funds are now just shy of US$12 billion.

At the same time, US Bond Funds continue to benefit from the belief among US-based investors that higher income tax rates are inevitable.

Overall, All Equity Funds absorbed a net US$10 billion for the week while All Bond Funds took in US$5.58 billion. Redemptions from Money Market Funds totalled US$7.1 billion for the week, taking year-to-date outflows over the US$450 billion mark.