Carry traders flee zero-yield dollar in emerg FX rush

Central banks across the developing world are signalling a retreat in the global currency wars, encouraging investors to flee the zero-yield dollar for emerging currencies even though the US money-printing exercise is approaching its end.

Recent weeks have seen the greenback hammered to record or multi-year lows against a raft of emerging currencies from the Korean won to the Brazilian real.

And the U.S. Federal Reserve's broad trade-weighted dollar index, adjusted for inflation, is at its lowest since 1973, when the old gold-backed exchange rate system collapsed.

That sets the stage for a fresh phase in the global carry trade, with the dollar being flogged off to fund purchases of higher-yield assets, usually in emerging markets.

While the Federal Reserve is preparing to wrap up its USD 600 billion bond-buying programme, known as quantitative easing (QE), the dollar remains under pressure because U.S. interest rates are unlikely to rise off current near-zero levels -- Fed boss Ben Bernanke told investors as much this week.

Emerging central banks meanwhile have started raising interest rates, effectively heralding a retreat in the currency wars -- a term coined last year by Brazil's finance minister -- in which countries vied to drive down the value of their currencies.

"It all comes down to the dollar. We don't expect the end of QE2 to support the dollar," said Claire Dissaux, investment strategist at currency fund Millennium Global. "It may affect liquidity at the margin but it's not going to jeopardise the fundamental trade into emerging currencies."

Emerging markets had sought to minimise the impact of QE2 with a raft of measures and capital curbs to deter hot money inflows and tamp down currencies. But the ground has shifted.

"Now they are ready to let currencies appreciate," said Dissaux.

That is keeping the rally intact -- currency gains should provide over half the returns for fund managers buying emerging local bonds this year, JP Morgan reckons.

One reason why emerging central banks now have less stomach to fight currency appreciation is China, which has been allowing the yuan to rise, taking some pressure off Asian neighbours. The other reason is fast-rising inflation, which is also prompting China and other emerging economies to raise interest rates.

JP Morgan estimates emerging central banks will hike rates by around 64 basis points on average by the end of 2011, taking them up from already high levels of 12% in Brazil, for example, and 6.75 percent in Indonesia.

"Rate differentials are being kept so wide, you are essentially paid to take risk in emerging FX," says UBS currency strategist Manik Narain.

The turnaround has been quick -- net dollar shorts versus the real for instance have shot up to USD 15 billion from flat in just a month on Brazil's securities exchange BM&F -- coinciding with signals that the real could be given more freedom to rise.

But stronger factors may be at play than mere yield demand.

"There's a fundamental story anchored to Asian growth. What you have is increasing monetary policy divergence, backed by better sovereign balance sheets (in emerging markets)," Dissaux said.

Treasury yields a worry

All may not be smooth sailing. Given extreme positioning, some markets may be ripe for a reversal, especially those like Turkey or Korea which are most wary of currency appreciation.

Narain of UBS says less abundant liquidity will lead to more differentiation between emerging markets based on their trade balances and willingness to raise interest rates.

But the big worry is what will happen to U.S. Treasury yields after the the Fed stops buying bonds. With Washington showing making little headway in tackling its debt problem and the dollar in freefall, there is a risk that non-U.S. buyers too may cut back on their U.S. bond investments.

A 100 basis-point rise in U.S. 10-year yields would cut flows to emerging markets by 23%, BoA/Merrill pointed out, citing IMF research.

"The key issue is not that money stops getting pumped in but what happens to Treasuries," says Phil Poole, global strategist at HSBC Global Asset Management. "If U.S. yields go up a lot, those (overseas) investments will start looking less attractive."

BoA/Merrill Lynch analysts, however, say estimates of QE2's impact are overblown, calculating QE2 "leakage" into emerging markets at USD 60 billion, or a tenth of the Fed bond purchases.

That amounts to a mere 6% pickup in gross emerging market inflows, BoA/Merrill said in a note, calling the spillover "small potatoes", given gross capital inflows to the developing world have been rising by 30-40% a year.

Poole, despite his warning over U.S. yields, agrees.

"If you think the world is flooded with excess liquidity and you stop pumping in more, then it's still flooded," he said. "People are looking for yield which is not available in the West ... I dont see where else that liquidity can be deployed."