FX traders pull back to vanilla strategies for emerging markets

Spreads tighten on many currency pairs but liquidity still patchy

Seeking-safety-in-the-dollar

Trading emerging markets currencies has fallen out of favour since the outbreak of Covid-19, with runaway volatility and blowouts in spreads for many currency pairs damping volumes in spot and forwards.

Although spreads are tracing back from their March highs, there are still reasons for caution, traders say.

“I don’t feel like we have necessarily hit the bottom because fundamentals now are shrouded with uncertainty. We’re probably going to see the impact of what’s going on in three months or so, and that means some negativity may still need to be priced in,” says Charlotte Hampshire-Waugh, head of trading and FX payments at INTL FCStone, a US broker.

Clients looking to trade emerging markets currencies should keep it simple, says Ashok Das, head of local Asia markets and solutions at Deutsche Bank, and focus on their basic needs for investment and hedging activities. The key is using pockets of liquidity when they become available in onshore or offshore markets, he says.

Investors should also be looking closely at the FX component of trades. When buying bonds, for example, real money investors need to use spot or non-deliverable forward (NDF) markets to “close the risk exposure”, Das says.

Traders are also looking at strategies to arbitrage the recovery from Covid across emerging markets. As some countries discuss whether to start relaxing lockdown measures or keep them in place, and others enter the second phase of the outbreak, the focus could shift on trading one emerging markets currency against another based on each country’s actions.

“While there’s no strong argument that one country’s FX should do significantly better or worse than others, if you have seen a bigger action in one place then maybe that’s just ahead of the curve, and one can trade relative value on the way back versus the other one that hasn’t moved so much,” says Stephen Jefferies, head of Emea currencies and emerging markets trading at JP Morgan.

But even this strategy might be hard to execute. According to Hampshire-Waugh, “there is no magic wand to put it on in one single trade. Every single country is on a different level. It is anybody’s guess when markets normalise.”

Spread far and wide

With coronavirus-driven volatility hitting highs in developed market pairs in March, bid/offer spreads on emerging market currencies widened by more than 1,000% in some pairs.

In spot markets, the spread on USD/MXN for example jumped from 0.02 basis points on February 26 to 0.3bp two days later, a 1,400% increase according to Bloomberg data. Similarly, the bid/offer differential rose by over 700% in both USD/ZAR and USD/TRY, between the end of February and mid-March.

In USD/MYR, the spread widened from 0.002bp for most of February to a peak of 0.014bp on March 30 – an increase of 600%. USD/BRL saw its spread jump from 0.001bp on March 16 to 0.006bp four days later, a 400% increase.

 

 

Wider spreads were also seen in FX options, with one month at-the-money USD/MXN for example rising from 0.6 vol points on February 25 to 5.9 on March 17. In USD/MYR, the spread rose from 4 points before the virus outbreak to 8.8 on March 12. In USD/TRY, it doubled to 4 points by mid-March.

 

 

Spreads have all since narrowed, but most remain wider than normal. By the last week of April, the bid/offer spread for spot USD/MXN was down to 0.06bp, which was still three times higher than February.

“Things are better now compared to March – that was a bit surreal,” says Stephen Chiu, an analyst at Bloomberg Intelligence. “Trading has normalised and at least you get both sides these days. In March, it was like everyone was just saying ‘I want dollars’.”

But some trades are still hard to execute. The head of emerging markets foreign exchange trading at one large dealer says they have seen less volume and volatility, which means it’s harder for investors to find the opposite side if they want to get out of a trade that isn’t working.

“There are still a lot of gapping moves and there’s nothing there to protect you. It’s probably a more difficult market now because the direction is less clear, and it’s hard to hedge even though bid/offer spreads are coming tighter,” the head says.

The drop in volume is also seen in emerging markets NDFs, with lower levels of trading in many pairs since the quarter-end.

Market participants have also been spooked by market dislocations caused by sudden closures of exchanges and reduced market hours in some countries.

“Take the case of the Philippines, where holidays were declared without notice in mid-March and risks for every single corporate and institution came into question,” says Deutsche Bank’s Das.

“How would clients square any risk on this day then? It is a very tricky position to be in because there is no underlying price,” he adds.

Anatomy of a crisis

At least initially, the spread of Covid-19 seemed to be contained to one Chinese province. This led emerging markets investors to continue to enter traditional positive carry trades, where money is borrowed in a low-yielding currency and then invested into a high-yielding one, with the objective of capturing the interest rate differential between the two.

Typical strategies included buying FX forwards, shorting FX volatility or owning bonds denominated in emerging market currencies, says Anant Swarup, global head of FX and emerging markets flow products at Nomura.

“That was the position that the market was in, when we went into these events. It was not until the US equity market started seeing significant stress, that this percolated across into all emerging markets currencies,” Swarup says.

At that point, getting out of the market, and quickly, became key.

“We first approached the crisis by reducing our higher beta currencies, such as the Mexican peso, the Brazilian real, the South African rand and the Turkish lira,” says Andreas Koenig, head of global FX at Amundi.

“When the virus broke out across Asia we underweighted local currencies such as the Korean won, the Chinese renminbi, the Malaysian ringgit, the Thai baht and the Taiwanese dollar and bought safe haven currencies like the Japanese yen,” he adds.

When markets tumbled at the end of February and early March, investors rushed to exit their positions and unwind their carry trades in response to widening spreads. As a result, FX volumes skyrocketed.

“March was a very high volume month for FX businesses,” says Nomura’s Swarup. “I would say that the volumes for us were three to four times higher than what we usually see in these products. This was a function of a lot of rebalancing of portfolios which had to be done in an unexpected way.”

Additional reporting by Natasha Rega-Jones and Chris Davis

Editing by Alex Krohn

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