A possible return to the carry trade strategy for 2017 is a rustling that echoes amongst some professionals and the international press. Despite the resonance that destabilising events like Brexit and US elections have internationally, the economic scenario is encouraging for such a strategy.
The Carry Trade Strategy
The carry trade is a short-term, currency-based trading strategy. It consists of borrowing in low-interest rate countries and investing in the ones that offer a higher yield on credit.
Gains are possible from the interest rate differential and the investing currency’s appreciation against the funding one. As ‘Uncovered Interest Parity’ does not hold in practice, a country offering a high-interest rate is likely to undergo an appreciation of its currency. In fact, it is a ‘random walk’ and exchange rate changes average zero, at least in the short term.
The strategy can be pursued either on one or a portfolio of currencies. A one-currency trade can be realised through forward contracts, bonds and equivalent instruments. Each method delivers the same result in no arbitrage.
While there is more than one technique for a carry trade on a portfolio of currencies, it is common to rank the basket of currencies chosen depending on the forward premium or other indicators, fund with the low-interest ones and invest in the top ones. At the end of the holding period, the investment’s proceeds are exchanged back to the base currency and profits result after returning the borrowed amount. The spectrum of currencies to consider is arbitrary.
Stability and Risk
For example, G10 currencies can be addressed as their interest rates’ range is wide enough to make profits, while containing risks due to the countries’ relative stability. Borrowing and investments obligations must match in maturity and the shorter the latter is, the higher the flexibility of the strategy since countries’ investment options differ. Considering, for example, a one-month period, the investment would use one-month Libor in the UK and a one-month deposit in the US. Eventually, as the carry trade is an operation repeated continuously for a long time, transaction costs are inferior to a new transaction.
The basic strategy only considers the safest assets, such as deposits and governmental bills. However, over time, investors sought to widen the interest rate differential. Investing assets and investing countries became riskier and riskier to stretch yields at maximum.
Until 2008 the negative correlation between market’s returns and the carry trade strategy had hedged carry trade investors from market downturns, but during the financial crisis the returns collapsed. Higher risk and an increase in volatility caused huge losses and investors had been reluctant to adopt this strategy again since.
The Trend Now
For carry trade to be effective and not overly risky, volatility should be low, as noticed in the 2000s, when the strategy rapidly grew in popularity. In contrast, volatility was high during the late 70s and 80s as can be seen in the exchange rate volatility between the dollar and the pound (see chart below). Therefore, the carry trade was not pursued during that time.
The measurements and valuations are usually based on options’ implied volatility or Arch Garch model. This shows investors’ risk aversion. The more volatile the exchange rate between the funding and investing currency, the more volatile are the outcomes of the carry trade. An example is offered by Citibank’s trading strategy of lowering volumes in high volatility periods and increasing them when volatility is low.
Interest rate stability among countries accompanied by low volatility may boost investors’ confidence in carry trade. This comes along with the restored credibility of monetary policies’ announcements and, inflation, which is negatively correlated with carry trade, expected to hold at low levels.
The euro and the pound are two currencies to avoid for funding, and this has always been the case. The first is far from the convenience of 2014 given by the ECB’s negative interest rates and the pound suffered wide swings after the Brexit referendum.
The Swiss National Bank, on the other hand, seems keen on maintaining negative interests on sight deposits making the Swiss franc a possibility.
The epic strengthening of the dollar against the yen represents an opportunity to borrow yens and go long on dollars. As an ulterior advantage, the Fed recently raised interest rates and is expected to do so again this year, while Japanese Government Bonds will still yield a zero rate for some time.
Australian and New Zealand dollars proved themselves as investing currencies. Although the Reserve Bank of New Zealand will decrease interest rates from 2.00% to a lower bound of 1.75%, it will still place high among the G10. Same for the Australian interest of 1.5%, which is likely to decrease to 1%.
Another investing currency is the Russian ruble. The Russian currency’s carry has yielded the highest return after the Brazilian real for developing economies in 2016, with the interest rate at 10% and an appreciation in 2016. The trend could extend to 2017 depending on how extensive relationships will be with Trump’s US and oil prices.
Conversely, the Indian rupee is unlikely to be allowed to strengthen further, affecting the country’s growth due to a lack of FDI.
Low inflation forecasts for the major currencies, low volatility and rising interest rates draw a palatable scenario. The carry trade even presents as a flexible investment – for example, rolling monthly orders allows liquidity in turmoil periods. What lacks is confidence from investors, but the market is fickle: today’s bearish may be tomorrow’s overconfidence.