EM central bank reserve accumulation to crush volatility and boost carry trade
EM reserve managers are starting to accumulate funds on a scale not seen for more than a year – a development that is likely to keep FX volatility down at its current low level and encourage investors into carry trades.
For the first time since mid-2011, EM central bank reserves are showing early signs of growth, despite trade balances holding near cyclical lows, says Richard Cochinos, FX strategist at Bank of America Merrill Lynch (BAML).
BAMLs high-frequency measure of the eight EM central banks that report reserves on a daily or weekly basis shows accumulation during the past two weeks is up $13 billion. That is well above average for this year or, given that it is just halfway through September, higher than any single month.
Cochinos says, when extrapolated across a global suite of 50 EM central banks, reserve accumulation in September should be in excess of $108 billion.
EM reserves on the rise, driven by real money flows
Source: Bloomberg, BAML
BAML says the flows are being driven by the financial not the current account side of the balance sheet, with private, real-money investors, predominantly in the US and Europe, rotating investment capital out of developed markets and into EM.
The bank says real-money flows explain a large share of the recent growth in EM reserves, and with the Federal Reserve becoming more dovish as it launches QE3, those trends are likely to flourish, breaking the stagnant reserve patterns between April and August.
Indeed, the banks latest rates and FX sentiment survey of real-money managers highlights an overweight stance on EM FX and debt.
With increasing assets under management, we find that the investment styles of reserve managers are changing, says Cochinos. This re-introduces typical flow rebalancing, but importantly it helps to limit G10 volatility.
EM bond flows outgrowing G10
Source: EPFR, BAML
One aspect of increasing reserves at EM central banks means that managers will recycle the USD they receive into other currencies, such as EUR, JPY, GBP, AUD and CAD.
Another is that it suppresses volatility in FX.
BAML finds that as the spread between reserve manager and hedge fund flows in the FX market increases, volatility falls. That is what is happening now.
The correlation between proprietary reserve manager flows and hedge fund FX flows captured by BAML has been falling recently and now holding a negative correlation of 35%.
That is in contrast to May, when the correlation was rising, implying that central banks were behaving like alpha-seeking investors.
Our explanation for the change was the weaker reserve growth than in 2010 or 2011, so that a greater share of official investments resulted not from flow rebalancing but management of existing capital, says Cochinos. The reverse is now happening.
Official flows are again contrarian to hedge funds
In other words, the more opposed reserve manager and hedge fund flows are, the more they move in opposite directions, and the lower the volatility of any given currency pair.
Cochinos says this means the current low levels of volatility seen across currencies might not be unfairly priced, even if perceived as too low compared with historic volatility. With EM FX reserve accumulation expected to increase in the near future, he adds, that means the low-volatility environment could continue for now.
Typically, these regimes support carry trades, says Cochinos. Given the flow argument, this should, in turn, find support for AUD, both from reserve rebalancing and carry flows.