CAD tops carry-trade funding rankings

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CAD tops carry-trade funding rankings

For all the talk that the recent liquidity injection by the European Central Bank (ECB) would spark a euro-funded carry trade, the Canadian dollar leads the funding currency rankings.

Low and falling rates and ample ECB liquidity are driving increasing speculation that the euro is acquiring the status of funding currency of choice. However, RBC Capital Markets says a strong consensus can often be wrong and while ample liquidity and low rates might be necessary conditions for the status of funding currency, they are not sufficient conditions.

The other side of the carry-trade coin, of course, is volatility and that is where the Canadian dollar edges out the euro.

RBC’s carry-trade barometer, which is based on the trade-off between yield spread and volatility, shows that the Canadian dollar is still the funding currency of choice, with the euro in second place.

 RBC's carry trade barometer rankings

 
 Source: RBC Capital Markets, Bloomberg

The Canadian dollar is the most efficient way to fund the purchase of high-yielding currencies, particularly in the commodity space.

“In simple terms, an efficient funding currency is a low yielder that tracks the performance of the high-yield position it funds, compressing volatility in the cross,” says Elsa Lignos, FX strategist at RBC.

“This is what propels the Canadian dollar up our rankings – it behaves like a high-risk currency, but has unusually low interest rates.”

Lignos says this will change only when the Bank of Canada hikes interest rates, but intuitively it makes a lot of sense to fund positions in, say, the Brazilian real or the Mexican peso, with a currency that has similar characteristics but yields a whole lot less.

“Although the euro has outright lower interest rates than the Canadian dollar, for now its higher volatility on high-yielding crosses outweighs the lower rate benefit,” she adds.

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