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Why the carry trade still isn’t working

For EURUSD bears, the recent slide of short-term euro interest rates below short-term Japanese interest rates – for the first time in modern history – should have heralded a new paradigm in the FX markets: the euro becoming the funding currency of choice, and perhaps the re-emergence of the carry trade as a profitable strategy.

Euro rates lowest in the world -  almost. Fit for funding?

Source: RBC, Bloomberg

Although there is little doubt that the euro is firmly in the camp of funding currencies, it should not be assumed that it represents the best value when considering how to fund the trade, says Adam Cole, director and global head of FX strategy at Royal Bank of Canada.

Indeed, RBC conducts analysis on the euro carry trade with its “carry trade barometer”, which looks to quantify the trade-off between yield pickup and volatility cross high/low yield currency pairs using option pricing.

The bank’s analysis shows that the Canadian dollar was the most effective funding currency, even though its short-term interest rates were significantly higher than euro short-term rates.

 CAD and EUR top of the pile as funding currencies

Source: RBC, Bloomberg

“For most high-yielding currencies, particularly those linked to commodities, CAD remains the most efficient funding currency,” Cole wrote in a report published today. “This is a natural consequence of CAD’s high correlation with other commodity currencies, which compresses volatility when one is crossed against the other.”

Nonetheless, the euro comes in as the second-most-effective funding currency due to its “strong tendency to trade with general risk appetite”. The report adds that although sterling’s safe haven status might be fading, GBP remains the third-most-effective funding currency.

However, is the carry trade the right strategy for today’s markets? The answer to that is ‘no', says Cole. The trade typically performs well in an environment where there are wide interest rate spreads and low volatility across a range of currencies.

The carry-to-risk ratio improved recently as volatility fell, thus raising the prospect of a re-emergence of the trade when compared with what RBC calls the “carry trade frenzy” of the mid-2000s. 

 Volatility too high to spur carry trade positioning 

Source: RBC, Bloomberg

“The problem with this turning into a widespread strategy is that the decline in volatility does not even come close to compensating for the compression of yield spreads,” says Cole.

For it to become a viable strategy and to snowball as it did in the mid-2000s, RBC’s best guess is that annualized aggregate FX volatility would have to fall to around 3% from current levels of 9% (realized) to 10% (current average implied). This is surely beyond the bounds of possibility, says Cole.

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