The truth about the future of the carry trade

Hamish Risk
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Once upon a time, the FX markets were easier to trade. Currencies traded on their macroeconomic fundamentals, unimpeded by politics, and unconventional monetary policy. The carry trade was king.

“In the glory days of carry, the FX market had the luxury of a clear framework for understanding and trading currencies,” reminisces HSBC in a report this week, titled The New Era for FX.

In this new era, HSBC states that the carry trade’s hold on FX has now waned as a result of global interest rates gravitating towards zero, forcing the FX market to react to the far more ambiguous implications of quantitative easing (QE).

In the market now dominated by risk on-risk off (RORO), the carry trade has suffered from the proverbial “spanner in the works” because, according to HSBC, there is considerable debate as to what QE means for a currency. Indeed, the implications of QE on currencies have not been uniform – they have become based on market perceptions, rather than some mechanistic link.

“Prior to ZIRP [zero interest rate policy], it was more important that carry was linked to a known transmission mechanism – one we understood, rather than the returns from carry itself,” states HSBC.

The report then sets out to explain how the move from conventional monetary policy to unconventional QE has created an unclear and complex picture for the FX market. While there has been an initial view that QE was uniformly currency negative, this has proved not to be the case. For instance, QE has proved to be USD negative, EUR positive, GBP neutral and mildly positive for JPY, says HSBC.

In conclusion, given such a mixed picture, equities, not FX, now provides a much cleaner mechanistic link between a given view and a price, writes HSBC.

So is the carry trade dead?

Don’t be too hasty in writing it off just yet, says Jessica James, head of FX quantitative solutions group at Commerzbank.

In a report published last week on the G10 carry trade – which runs with the subtitle Reports of the Death of G10 Carry are at Least Somewhat Exaggerated – the German bank conducted a study of all 45 G10 currency combinations, and James’ quant group found that G10 currency performance had been broadly similar to typical historical performance, such as was seen between 1990 to 1992, 1993 to 1995 and 1998 to 2002.

What partly might explain the declining interest in the carry trade is that returns in the lead up to the beginning of the financial crisis in 2007 were exceptional, largely driven by spot moves rather than interest-rate differentials.

 Carry trade returns were exceptional pre-2007

 Source: Bloomberg; Commerzbank

“Looking past the favourable spot-rate developments, it is also evident, however, that steady broad-basket carry trade profits can be accrued, even when rate differentials are relatively low,” writes James.

Since the second quarter of 2009, the unleveraged G10 carry trade returned 4.9% in USD terms and 9.4% in euro terms. The group also notes that average rate differentials around the turn of 2012 was only 0.25 percentage points lower than was the case immediately prior to the financial crisis.

So what is all the fuss about the demise of the carry trade?

According to Daragh Maher, one of the authors of the HSBC report, the changing dynamics of FX markets mean investors need to understand that factors other than carry might be dominating these trades.

“You have to identify that what you’re playing isn’t necessarily carry,” he says. “In many instances, you’re taking a view on risk. And while investors might still be garnering a return from carry, there is greater volatility now – and so volatility-adjusted returns look less attractive.”

He cites the example of AUDJPY, one of the best-performing carry trade currency pairs as an example of this. The AUDJPY has continued to do well. However, much of that is attributable to the risk-on trade. As the chart below shows, AUDJPY has become more correlated to the S&P 500, a key measure of RORO.

 Risk-on causing AUDJPY carry trade to do well

 Source: Bloomberg; HSBC

For instance, in the traditional carry environment, one would anticipate that local economic numbers would still have traction on the currency pair, so if economic numbers surprised on the upside, one might anticipate a rate hike, while if they were worse than expected, one might expect rate cuts.

HSBC uses its own economic surprise index – a measure of disappointment versus upside surprises – to prove this point. It shows the index trending downwards – that is, more disappointments than upside surprises – which typically meant the trade-weighted index of those currency pairs would follow it or track it. However, in this instance, it did not.

“The reason is that these currencies are looking outward [beyond domestic macro-fundamentals] for a lot more for their impetus,” says Maher.

 HSBC AUD surprise index

 Source: Bloomberg; HSBC

 HSBC JPY surprise index

 Source: Bloomberg; HSBC

Commerzbank does concede that macroeconomic data developments have taken a back seat to QE, making risk-adjusted returns difficult to predict and therefore giving some investors cold feet. However, current returns from the carry trade need to be put into context.

Its analysis indicates that returns since the crisis have been especially poor, and negative in most cases when a particular cross-rate is influenced by the policy of two of the central banks conducting QE – the Federal Reserve, Bank of England, European Central Bank (ECB), Bank of Japan and Swiss National Bank. However, it points out that a sharp differentiation between central bank policies has enhanced risk-adjusted returns in some cases.

 Carry trade returns weaken when rates are influenced by QE from two central banks

 Source: Bloomberg; Commerzbank
Risk-adjusted returns in SEK, NOK, DKK, CAD and AUD since 2009 have, in some instances, been higher than has been the case in the long run. It is clear, however, that given the actions of central banks, there has been a reduced universe of available carry trade pairs.

Based on a carry basket that chooses the three highest-yielding currencies versus the three lowest-yielding currencies, Commerzbank found that, as at the end of the second quarter of 2012, the carry basket consisted of AUDCHF, JPYNOK and USDSEK for seven consecutive quarters.

Interestingly, since 1990, there has only been one other occasion when the basket went unchanged for longer than five consecutive quarters: 1997.

And while HSBC might argue that QE actions by central banks have made the carry trade more ambiguous, by the very nature of central bank actions and their continued commitment with ZIRP, the likelihood is that rates will remain lower for longer than would be the case in a normal business cycle. As a result, these returns might persist for longer, states Commerzbank.

“Strong commitments from the Fed and ECB have in addition seen FX-implied volatilities decline, traditionally a favourable development for the carry trade,” writes James.

This article was originally published by EuromoneyFXNews.