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FX comment: Death of the carry trade may be exaggerated

Bloomberg Businessweek carried an article last week positing that an exodus from carry trades – in particular those featuring USD as the funding currency – would encourage the rise in the dollar index seen since the beginning of November. But while it is likely that a mass liquidation of carry trades would lead to some dollar buying, such liquidation is still far away. Just because 2010 was a bad year for currency carry does not make it a failed strategy.

The basis for the article is the latest monthly report of the UBS V24 Carry Excess Return Index. UBS has published the index since late 1998. It is true, as the article says, that carry as a strategy in 2010 lost 2.5%, according to the index, and that is “more than the 0.98% drop in 2008... and the worst performance for so-called carry trade” since the inception of the index. But those two negative years are the only losers; 2009 returned 13.9% and the index has returned an annualised 14.2% since 1998. UBS’s timing in launching the index to clients as an investable strategy in late 2007 was unfortunate, but even since that date it has returned an annualised 2.42%.

UBS’s methodology is open to question. Other means of playing the carry game exist: more or fewer trades; more or fewer currencies; or creating hybrid signals with purchasing power parity, trade flows, volatility, momentum or a myriad of other indicators. UBS’s method has rigour and simplicity; out of a menu of 24 currencies, the six highest yielders are bought and the six lowest yielders are sold; additionally a volatility filter is applied to “gauge periods of high risk aversion”; when triggered, the filter unwinds positions to cash. All very well: a methodology that has no room for discretion or, as UBS puts it, a “transparent and systematic investment strategy”, can sit comfortably with investors. But how many of them would have willingly been sellers of CHF throughout 2010? Apart from the SNB of course.

It must be strenuously pointed out that it isn’t UBS that is proposing the end of the dollar carry trade, although the bank’s USD view – and that of its chief currency strategist Mansoor Mohi-uddin – is to be “bullish on the greenback in 2011.” But there are also prominent commentators who are USD bears, and they probably number more than those in the UBS camp.

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