Things reversed in 2018, which de Sousa says was a bad year for EM local currency fixed income. It got even worse for carry trade in 2020 and 2021, when emerging market economies acted very aggressively to stimulate their economies and the U.S. dollar gathered strength. At that time, the differential between rates in developing countries and advanced economies reached an all-time low of 2.2% in March 2021.
“When EM local currency debt becomes more attractive, it tends to support the currencies of emerging markets,” he says. “Year to date, even though the dollar has strengthened, it’s gained much more against other developed country currencies than it has against emerging market currencies.”
Even prior to that, EM currencies were already quite weakened after four or five years of bad returns, which limited the degree to which the greenback could gain against them. Complicating matters, de Sousa adds, is the fact that the carry, or the cost to short emerging market currencies, has gotten very high.
In the first seven months of 2022, he says the dollar strengthened 10.7% against the major currencies of the world, which except for China are all developed country currencies. But against emerging market currencies, the dollar strengthened by 6.4%.
“Fixed income has been horrible this year for everyone, across all sub-asset classes,” de Sousa says. “But from a total return perspective, EM local currency debt has actually been quite resilient on a relative basis. Up to the end of July, EM local currency debt had fallen by 14.3%, much less compared that to other fixed income asset classes.”
