The U.S. dollar has been the foreign exchange world’s carry trade of choice in recent years, an inevitable outcome of the rock-bottom rates created by the Federal Reserve’s quantitative easing. But a number of foreign exchange and macro hedge funds are trying small positions that use one Asian currency to fund another. It is a trade that might serve as a hedge against a dozen possible scenarios that include economic downturns that hit Asian markets unequally, as well as a sudden appreciation in the dollar or the second-most popular funding currency, the Japanese yen.
Take FX Concepts—the world’s largest currency hedge fund, with approximately $8.5 billion in assets—which uses 15 different trading models in its Global Currency Program, with $3.2 billion in assets under management. A carry trade involves borrowing in a low-interest currency and using those funds to invest in a higher-yielding one to create the carry. Among FX Concepts’ models are several short positions in which the fund borrows the Philippine peso to fund long positions in the Indonesian rupiah. “The risk profile is similar, and the offshore borrowing rates on the peso are low,” says Jim Conklin, a managing director and head of research at FX Concepts. As of early June the overnight borrowing rate in the Philippines was 4.5%, compared with 6.75% in Indonesia. FX Concepts has borrowed pesos offshore and onshore and also uses a model with long positions in the peso as a hedge against its short ones. The Asia portion of the Global Currency portfolio rose 4.49% over the 12 months through May, although the portfolio itself was down 7.77% over that period. The bulk of the losses came from developed Europe.
The Thai baht is also a good funding currency, according to Win Thin, global head of emerging market currency strategy at Brown Brothers Harriman. Even though Thailand also faces inflation pressures and its central bank has boosted borrowing costs four times this year, Thin says that the baht has lower borrowing rates (now about 3%) and weaker fundamentals than other neighbouring countries combined with political risk. “You want weak fundamentals and low interest rates for carry trade,” Thin says. “In Asia you usually have to sacrifice one of these, but not with the baht.”
None of Asia’s interest rates can compare with the U.S. dollar’s 0% to 0.25%, and indeed, the standard strategy for betting on Asia’s top performing currencies—such as the Indonesian rupiah, Malaysian ringgit, Korean won and Singapore dollar—is to buy them long against the U.S. dollar. Tim Lee, who runs the investment advisory firm Pi Economics in Stamford, Conn., estimates that U.S. dollar carry trades have totalled more than $1 trillion since the U.S. Federal Reserve began the first round of quantitative easing in 2008, based on International Monetary Fund
data. “QE2 created a further leg to it, putting it well above the previous credit-bubble peaks,” Lee says. Now that it’s over, he expects to see an unwinding of the U.S. dollar carry trade.
“In the next two to three years, there could be an upward turn in the U.S. dollar,” says Jim McCaughan, chief executive of Principal Global Investors, a hedge fund group that owns majority shares in the $5 billion Macro Currency Group and is in the process of acquiring a majority stake in Finisterre Capital, a long/short emerging-markets total return specialist. “If I were trading with U.S. dollars as the funding currency, I’d be very wary and have stop-loss orders in place.”
Traditionally, there were plenty of reasons not to use one currency of an emerging Asian market to fund another. Although their liquidity is strong by emerging-markets standards, these currencies do not offer the liquidity assurance of the U.S. dollar, and in the past the spreads between interest rates have not been nearly as high as those in Latin America. But the spreads are growing in the current inflationary cycle, and subtle differences and inefficiencies can produce relative value prices from inter-Asian long/short plays, generally as short-term positions.
“Certainly we’ve seen growth in Asian macro,” says Veryan Allen, CEO of Allen Investment Advisors in Tokyo, a firm that advises investors on hedge funds. “It used to be denominated by bottom-up trading. But now it’s more event-driven, currency-driven macro trading.” Allen says borrowing against short positions in one Asian currency to fund long plays in another makes sense if you have a predictive edge.
Another reason for playing Asian currencies this way, says McCaughan, is that in short-term trading, the Asian markets that are commodity consumers, such as the Philippines, Thailand, Taiwan, and Korea, might move against those that are commodity producers, such as Malaysia and Indonesia.
“If you’re leveraged this way you can make a lot of money—or lose a lot of money—when the commodity markets become volatile as they did in May,” he says. “I think we’ll see that happen again.”
But the yen remains the most widely-used carry trade funding currency after the dollar, especially since the G-7 intervened to calm the yen’s unexpected rise and fall following the earthquake and tsunami in March. “The yen carry trade is smaller now than it was in 2007, when I estimate that it peaked above $1 trillion, but still substantial,” Lee says.
Currencies that have been on the receiving end of the yen carry trade, he says, have included the Korean won, the Australian dollar and the New Zealand dollar, the latter two of which often function as proxies for emerging Asian currencies.
The recent rate of approximately ¥81 to $1 is a price that is not supported by Japan’s economic outlook, says Christopher Watson, head of research at Finisterre in London, which invests in Asian currencies through its flagship Global Opportunity Fund. “Being on the wrong side of the yen carry trade is clearly painful,” he says. “But it’s trading at high levels based on its history, and it looks expensive in relation to the dollar.”
Finisterre is using the yen as a carry trade in many of its positions. Devin Lo, a portfolio manager for the Global Opportunity Fund, says he is using long-dated money options instead of cash positions because the volatility in the market means that “the best sorts of Asian FX trades are those that keep the cash position small and nimble.” A good example of such a position, says Lo, is using yen money options to buy dated risk reversals on the Korean won.
“A won-dollar position would be similar, but the skew is larger with the yen,” he says. The Global Opportunity Fund, which manages about $1.09 billion of Finisterre’s $1.69 billion in assets, has declined 3.7% this year after posting gains of 10.58% in 2010 and 35.6% in 2009.
In the past, emerging Asian currencies were closely correlated, a situation that produced particularly dire consequences when the currency markets collapsed in 1997 and 1998, all having run large budget deficits funded by hot foreign money that eventually stopped flowing in. The fundamentals have diverged to a certain extent in recent years, but the use of interregional hedges will work only as long as Asia has a significant number of currencies that are likely to appreciate. Most fund managers investing in the region expect to see continued appreciation over the long term, but the strength is dependent on continued economic growth in the country that dominates the region: China. Now that the Chinese government is gradually allowing the currency to float, a fund that invests in Asian FX has to keep a wary eye on China’s regulatory decisions, since the value of the yuan remains largely a function of government policy. China is now allowing a slow appreciation of the yuan to fight inflation, but an economic downturn, as some China-watchers are predicting, could change that policy.
“The biggest tail risks to Asian currencies for the immediate future come from a hard landing for the Chinese economy and the possibility of higher U.S. interest rates,” says Russell Thompson, chief investment officer of the Cambridge Strategy, a London-based FX fund with about $1 billion in assets. Its Asian markets alpha program fell 0.89% this year through mid-June, with an annualized performance rate of 11.24% since the Asian-focused fund’s inception in 2006.
Thompson is using the dollar to buy currencies; the ones he likes best are the yuan, the won—which he sees as undervalued—and to a lesser extent the Malaysia ringgit. “We aren’t materially short in anything now,” he says, “although India is more vulnerable than others because of its fiscal problems.”
He thinks the best of the Asian currencies are likely to remain strong in relation to the U.S. dollar at least until the end of the year. But at the same time, he is considering what will happen if, in the second half of 2011, the FX market experiences a risk aversion rally—a trend he thinks could begin sometime this summer. In that case, investors would turn back to the U.S. dollar as a safe haven, as is traditionally the pattern in a risky economy.
“If that scenario develops, we’d go long on dollars and short on Asia,” says the Cambridge CIO.