Keep calm and carry on; carry trade returns to FX market

By:
Peter Garnham
Published on:

The carry trade, one of the investment styles that forms the basis of arguments that foreign exchange should be treated as an asset class, has made a comeback.

The re-emergence of the carry trade should be welcome news to currency fund managers , who have found consistent returns hard to come by in recent years, as FX markets have remained enslaved to the risk-on/risk-off phenomenon. The carry trade, in which the purchase of high-yielding currencies is funded by selling low-yielding currencies, was a source of consistent returns in the FX market ahead of the financial crisis.

According to purchasing power parity theory, carry trade strategies should not offer excess returns over time, as currencies of low-interest rate countries should appreciate to compensate for lower returns.

However, before the financial crisis, higher-yielding target currencies, such as the AUD and NZD, outperformed lower-yielding funding currencies, such as the JPY and CHF, as investors, buoyed by increasing optimism, leveraged their positions further and increased their use of funding currencies.

However, yield compression and soaring volatility – which can quickly erase any gains accrued from interest rate differentials – put an end to the effectiveness of the carry trade as an investment style, as the massive wave of deleveraging following the collapse of Lehman Brothers in 2008 wreaked havoc across financial markets. Now there are signs that carry trade has returned. The AUD on Thursday hit its highest level against the JPY since the start of the financial crisis.

Meanwhile, the Vix index of equity volatility hit its lowest levels since June 2007. It would seem that investors are becoming more confident that global growth and loose global liquidity will ensure financial market stability, and therefore encourage increasing demand for carry trades. Of course, since the start of the financial crisis there have been a number of false dawns for carry trade investors.

The evidence suggests, however, that this comeback has been sustained. UniCredit has constructed a relatively simple carry-trade basket. It ranks all G10 currencies against the USD using two-year swap rates and then goes long the top 20% and short the bottom 20%. Naturally, the AUD and NZD constantly feature at the top of the list, while the JPY and CHF are at the bottom.

As can be seen from the chart below, the carry basket performed poorly as concerns about Greece’s possible exit from the eurozone weighed on risk appetite in the spring of last year.

However, since the pledge by Mario Draghi, European Central Bank (ECB) president, that he would do “whatever it takes” to save the euro, the subsequent announcement of the ECB’s outright monetary transactions programme and QE3 from the Federal Reserve, carry trades have shown convincing signs of recovery, with the carry basket delivering consistently positive returns.

 
Carry returns consistently positive since 2012

Vasileios Gkionakis, head of global FX strategy at UniCredit, says around the end of August and start of September last year, the “great market re-allocation” toward more risk began to emerge. He says investors took comfort that central banks were responding effectively to tail-risks and decided to start reducing cash levels by putting their money to work.

“Risk-taking took centre stage and so the carry trade started to benefit once again,” says Gkionakis.

“During September and October, this was a natural response to central bank action, but in November and December it was compounded by improvement in the economic data across the board that alleviated worries over China and the US hard landing.”

There is more good news for carry trade investors. Not only did returns pick up but the volatility of carry started dropping steadily.

The 12-month rolling volatility of UniCredit’s carry basket stood at an annualized 12% in June, but fell to 8% during the last quarter of 2012. Therefore, with spot returns rising and volatility falling, the resulting rise in risk-adjusted returns underpins the notion that the “great reallocation” towards a risk-on environment is well under way, according to Gkionakis.

Extending the analysis to include 16 EM currencies in the carry basket, UniCredit found similar results, with returns rising and volatility falling.

The key to whether it continues is global risk appetite, and whether the current optimism can be maintained.

There are good signs that some of the greatest worries over the world economy are waning. The ECB has for now allayed fears over the break-up of the eurozone, while the Chinese and US economies appear to be over the worst.

Crucially, if that optimism holds, it will prompt investors to put their money to work.

Investors’ cash positions are still elevated, notes Gkionakis, and as risk appetite rises, they will not want to miss yet another rally and will therefore deploy resources to riskier positions.

“Typically when this happens, carry strategies benefit significantly,” he says.

Indeed, judging by the size of the gains made in currency pairs such as AUDJPY, not to mention NZDCHF, ahead of the financial crisis, the carry trade is a bandwagon that investors will be eager to jump on.

If it continues, expect more gains in the likes of AUD and NZD – and RUB, INR and MXN in the emerging world – while JPY and CHF are likely to come under significant downward pressure.