Emerging Market Macro Trades
Emerging-market rates, currencies, and sovereign bonds pay higher expected returns than developed markets partly for a real reason — political and policy risk that developed markets mostly don't carry — which is exactly what an EM macro trader is underwriting.
Prerequisites: Contango and Backwardation
An investor buying Brazilian local-currency government bonds is not just underwriting Brazil's interest-rate risk — they're underwriting the Brazilian real's exchange rate, the country's fiscal trajectory, its central bank's credibility, and the chance that a change in government upends the whole picture. All of that risk gets paid for, on average, with a higher yield than an equivalent developed-market bond offers. Emerging-market (EM) macro trading is the business of deciding, market by market, whether that extra yield is fair compensation or a trap.
EM assets typically offer a risk premium over developed markets for currency, political, and institutional risk that developed markets mostly don't carry. An EM macro trade is a bet on whether that premium is being priced correctly, too generously, or not generously enough, given the country's specific fundamentals.
The three legs of an EM trade
An EM macro position usually touches at least one of three markets: local rates (the country's own government bond yield curve, in its own currency), FX (the currency itself, since local-currency returns depend heavily on whether the currency holds up), and hard-currency sovereign debt (bonds issued in dollars or euros, which strip out currency risk but leave default risk). A classic EM carry trade borrows in a low-yielding currency like the yen and lends in a high-yielding EM currency, collecting the rate differential as long as the EM currency doesn't depreciate enough to wipe it out.
Worked example
A fund borrows yen at 0.5% and buys 2-year Brazilian local government bonds yielding 10.5%, converting via spot USDBRL at 5.00, then to yen. Over one year with the position unwound, the carry earned is roughly before currency moves. If the real depreciates 4% against the yen over the year (via the dollar cross), the net return falls to roughly — still positive, but the currency move ate 40% of the carry. If instead the real had depreciated 12%, the trade would have lost money despite correctly picking the higher-yielding bond, because the currency risk dominated the rate differential.
What this means in practice
EM macro desks spend disproportionate effort on the things that don't show up in a yield curve: central bank credibility, election calendars, current-account deficits that signal how exposed a currency is to a sudden stop in foreign funding, and correlation to global risk appetite — because EM assets as a group tend to sell off together whenever developed-market risk appetite falls, regardless of any single country's own fundamentals.
EM carry trades are a textbook negative-skew position: steady small gains from the rate differential most of the time, with occasional sharp, correlated losses when a currency crisis or a global risk-off episode hits many EM currencies simultaneously — "picking up pennies in front of a steamroller" is the standard description for a reason.
Related concepts
Practice in interviews
Further reading
- Ilmanen, Expected Returns (ch. 8, currency and EM)