According to WooFunai, Bloomberg data on August 23 showed that dollar-funded emerging market arbitrage transactions recorded positive returns for the seventh consecutive quarter, setting the longest winning streak since 2008. Behind this phenomenon is the “arbitrage, arbitrage, arbitrage” logic described by Cathy Hepworth, head of the PGIM (PRU.US) emerging market debt team: “This is an arbitrage world” because “there is a huge amount of money looking for profit”. The core driving force behind the inflow of capital is not the rise of a single asset, but the ultimate rebalance of global liquidity between low-interest and high-interest assets.
Deconstructed from the revenue structure, interest spreads and exchange rates form a two-wheel drive engine. Since the end of 2024, the strategy's cumulative return was about 22%, while the return on US Treasury bonds during the same period was only 5.9%, emerging market sovereign US dollar bonds were 14%, and corporate bonds were 10%. The profit from arbitrage transactions was nearly 4 times that of US bonds. The PGIM team, which manages $1.5 trillion, points out that the traditional practice is to use low-interest currencies such as the US dollar, yen, or euro to buy bonds in high-interest currencies such as the Turkish lira, where interest returns can reach more than 40%.
What really amplifies earnings, however, is exchange rate changes: the US dollar weakens against emerging market currencies outside of Asia, and at the same time, it also depreciates relatively against financing currencies such as the euro and the Swiss franc. Colombia's performance was the most extreme, with 12% bond returns compounded by 45% spot appreciation; even when the Turkish lira falls 26% against the US dollar, the yield of over 32% on 10-year local currency bonds ensures investors are profitable. In the past 12 months, US dollar financing arbitrage earned 48% on Colombian pesos, 23% in Turkish liras, 21% in Brazilian reais, 19% in Mexican pesos, and 18% in South African rands.
According to data compiled by WooFunai, this multi-currency combination effect allows even if some currencies depreciate, the overall portfolio still covers losses and achieves excess alpha through high interest rates.
Recent market fluctuations have tested the resilience of this strategy. At the beginning of July, arbitrage capital clearly shifted from developed markets to emerging markets, and the US dollar was snubbed; on July 23, the yen fell to a new low of more than 40 years. At the beginning of August, the US and Japan implemented joint foreign exchange market intervention, but the impact was far less than the impact of August 2024, which caused the Bloomberg Emerging Markets Foreign Exchange Arbitrage Risk Premium Index to fall by 4%. This time, the index only fell by about 1%. The reason is that the financing currency was switched: the yen position was replaced by the euro, the Swiss franc, and the US dollar. ThierryLarose, portfolio manager at the Swiss asset management agency Vontobel, said that “the threshold for disorderly closing positions is higher than I thought a few weeks ago” and that he continues to arbitrage but bypass the yen. The intervention failed to reverse the yen trend. The yen returned to the 159-160 range in mid-August. Although hedge fund yen bears fell to 59,526 lots, some arbitrators used the rebound to rebuild their bears. On August 17, the emerging market currency index hit a record high of 1906.98, indicating that bullish momentum has not abated.
Future risks focus on the Federal Reserve's policies and trading congestion. On Wednesday, the US Treasury announced an increase in long-term bond repurchases. DanielVonahlen, head of macro strategy at TSLombard, pointed out that “the US government's tolerance for rising bond yields appears to be very low”. This has catalyzed lengthy arbitrage in emerging markets, and its corporate indicators “improved again.” KamakshyaTrivedi, chief foreign exchange and emerging markets strategist at Goldman Sachs (GS.US), believes that “improving inflation is enough to keep the Federal Reserve on hold,” but warns that rising long-term interest rates are a threat; Ning Sun, senior emerging market strategist at STT.US (STT.US), said bluntly that US data is not weak enough to reverse risk appetite.
However, crowding is a potential hazard, and this strategy may fall victim to its own success. Support includes Latin American and Eastern European central banks maintaining high interest rates to suppress inflation, as well as the situation in the Middle East and high energy prices preventing easing. Alejoczerwonko, chief investment officer of UBS (UBS.US) Emerging Markets America, favors Euro and Canadian dollar financing, going long for South African rand and Mexican pesos; PGIM's Hepworth is optimistic about frontier markets in sub-Saharan Africa, as well as Turkey, Colombia, and Brazil. This is the first time since the 2008 financial crisis that arbitrage trading in emerging markets has shown such a lasting structural advantage, but once macro expectations are reversed, the risk of stepping on will rapidly increase.