A number of emerging markets with substantial foreign funding requirements encourage foreign investors to own their short-term debt, which pays a substantially higher interest (or “carry”) than US dollars. This is a favorite hedge fund trade, although a dangerous one: It’s like picking up pennies on a volcano. If the volcano starts to erupt, it’s too late to run for safety.
With this week’s rise in commodity and oil prices and a corresponding rise in US bond yields, the volcano has started to smoke. The Mexican peso in particular is highly vulnerable to an eventual rise in US interest rates. During the past week, the peso has traded almost tick for tick with US interest rates (shown on the chart below is the current 10-year Treasury future). By midweek the Brazilian real began to trade in tandem with the US Treasury yield as well.
This is a new development: during the past several years, there has been almost no correlation between US interest rates and the “carry currencies.” Evidently, US rates have reached a threshold past which the EM currencies become vulnerable. That’s very bad news: What it suggests is that an entire range of trades around the world funded with low-interest money might go sour as the cost of funding increases.
Latin American currencies (and the Turkish lira) are exposed, but so is a great deal of commercial real estate in the United States, the bubbly housing markets in Canada and Australia, private equity acquisitions financed by junk bonds, and other beneficiaries of the low interest rate environment. The Mexican peso may turn out to be the canary in the coal mine.