Is the Indian Rupee the Ideal Carry Trade Currency Amidst Overcrowding Concerns?

Key Takeaway

• The Indian rupee's stability and low volatility make it a preferred carry trade currency, supported by RBI's interest-rate pause and record forex reserves.
• Despite lower yields compared to the Mexican peso or Turkish lira, the rupee offers lower correction risk, with its fair value seen at 82.50 per dollar.
• Overcrowding in rupee carry trades is noted, with major banks like JPMorgan and Goldman Sachs strategizing re-engagement levels amid strong domestic demand.

Rupee Stability and Carry Trade Appeal

The Indian rupee has emerged as a stable and inexpensive currency compared to its emerging market peers, making it a preferred choice for carry traders, according to Bank of America Corp. David Hauner, head of global EM fixed-income strategy at the bank, stated, "If you hold it for the carry, you don’t have much risk that it will depreciate a lot, which would be a greater risk in some of the other carry trades." The rupee's stability is attributed to a prolonged interest-rate pause by the Reserve Bank of India (RBI) and record foreign exchange reserves.

Data compiled by Bloomberg shows that going long on the rupee is the only carry trade to yield positive returns against the dollar in Asia this year. The one-month implied volatility in the dollar-rupee hit its lowest in a decade, reflecting the RBI's strong control over the currency. Although the rupee does not offer as high a yield as the Mexican peso or Turkish lira, the risk of a correction is lower. Hauner sees the rupee's fair value at around 82.50 to a dollar, more than 1% higher than current levels.

RBI Governor Shaktikanta Das emphasized the rupee's stability, citing the country's sound economic fundamentals, financial stability, and improved external outlook. "The rupee’s relative stability bears testimony to the country’s sound and resilient economic fundamentals," Das said at a press briefing after the RBI left borrowing costs unchanged for the eighth consecutive meeting.

Overcrowding in Rupee Carry Trade

The rupee's popularity as a carry currency has led to overcrowding in the trade. JPMorgan Chase & Co. is awaiting better levels to re-engage, while Goldman Sachs Group Inc. analysts noted that the rupee's carry attractiveness increases when paired with short positions in the euro and Chinese yuan. Bank of America has also been recommending clients to go long on the rupee funded by some North Asian currencies. Hauner pointed out that India has higher interest rates and is driven by stronger domestic demand compared to China.

Emerging-market investors are increasingly turning to local bonds and relative-value currency trades following election shocks that disrupted long-standing bets in major emerging economies. Christine Reed, a portfolio manager at Ninety One, mentioned, "We’ve been increasing the frontier risk, through both local bonds and FX derivatives." Reed also highlighted a constructive outlook for Turkey, where economic policy overhauls have led to a surge in demand for local-currency assets.

Election Impact on Emerging Markets

The search for new pockets of returns has intensified after election surprises affected some of the best trades of 2024. Mexico's peso experienced its worst week since the onset of the pandemic, with volatility spiking as traders reacted to potential economic reforms following Claudia Sheinbaum's landslide win. Gustavo Medeiros, head of research at Ashmore in London, commented, "Mexico is a good story, which got a bit muddled."

Investors are also looking at the Polish zloty, which benefits from high carry and low political uncertainty. Bartosz Sawicki, a market analyst at Polish brokerage Cinkciarz.pl, suggested that the zloty could be a viable option. T Rowe Price is adopting relative value trades, buying the Colombian peso while selling its Chilean counterpart. Aaron Gifford, a sovereign analyst at T Rowe in Baltimore, explained, "During risk-off periods EM FX carry trades tend to underperform because they’re riskier than safe haven currencies."

Street Views

• David Hauner, Bank of America (Bullish on the Indian Rupee):

  "If you hold it for the carry, you don’t have much risk that it will depreciate a lot, which would be a greater risk in some of the other carry trades."

• Goldman Sachs Analysts (Bullish on the Indian Rupee):

  "Its carry attractiveness gets boosted further when paired with euro and Chinese yuan short positions."

Management Quotes

• Shaktikanta Das, RBI Governor:

  "The rupee’s relative stability bears testimony to the country’s sound and resilient economic fundamentals, financial stability, and improvement in the external outlook."