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Foreign Exchange

Greek crisis not death blow for FX carry

The best route to navigate the current FX environment involves balancing the twin approach of risk on/risk off with traditional interest-rate differentials, says HSBC, as carry considerations begin to have more influence on exchange rates.

The financial crisis and ensuing global recession, which forced many central banks to slash interest rates to zero, transformed the FX world into a market dominated not by interest rates but by risk considerations, in which a given currency’s direction was determined by whether sentiment was risk on or risk off. However, casual observation of the recent behaviour of several G10 currencies indicates rate expectations might be carrying more weight.

GBP’s movements have been seemingly largely related to how hawkish or dovish the Bank of England is perceived, while AUD suffered heavily after a bigger-than-forecast rate cut by the Reserve Bank of Australia.

The behaviour of the USD has also shown a more positive correlation with good US numbers, where previously it might have suffered due to a diminished safe-haven bid. A sustained run of above-expectation data results could, in turn, be expected to alter the Fed’s course of ultra-loose monetary policy.

“These are nascent signs that carry considerations are trying hard to reassert their influence in G10 FX,” says David Bloom, global head of FX strategy at HSBC.

Investigating the extent to which carry considerations influence FX movements, HSBC calculated correlations between daily returns in G10 crosses and the change in their respective interest-rate differentials.

An average six-month correlation coefficient was computed for all 45 exchange rates. The higher the coefficient, the more rates are influencing currencies.

 Interest rate differential correlation with G10 FX

Source: HSBC

The analysis shows that, since the beginning of the year, FX correlations with rate differentials have continued to rise and are now at levels observed ahead of the global financial crisis when “carry” was the main consideration.

“The rising influence of interest-rate differentials came earlier than we expected, and at a time when the influence of risk on/risk off is still the dominant feature of the market,” says Bloom.

He adds that the FX market might not have migrated back to data-dependent central bank watchers, but an exclusive fascination with risk considerations is equally misplaced.

While the latest round of risk off in the wake of political crisis in Greece – and the effect this has had on currencies – demonstrates that risk sentiment remains a dominant short-term driver, it is important to acknowledge it is not the only game in town.

“The best trades are when the two line up and you get the double whammy," says Bloom. "For example, rate cuts by the Australians for domestic reasons and a large dose of risk off due to the eurozone, would amplify a downward move of AUD”

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