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It's the Carry-Trade, all right ..... but not necessarily as we remember it

June 5, 2018

 

ref :- "Dollar Is Driving Some Carry-Trade Returns despite Volatility" , Bloomberg Markets

 

Ah, our old friend the Carry-Trade ..... we haven't really seen it for a while. A bread-and-butter trading strategy and a huge factor in foreign exchange markets, it essentially revolves around investors borrowing low-yielding currencies and selling them to buy high-yielding ones. The interest rate differential between the two is profit for the investor, whilst the possible fly-in-the ointment is the danger that a fall in the value of the "long" currency wipes out that profit, or worse.

 

Typically when one talks of carry-trades the "long" currency of choice has been a high-yielder from emerging markets, whilst the funding currency has been an ultra low-yielding example such as the Jap Yen. That being so, the optimum conditions for the trade is a low-risk, low-volatility environment where the investor can not only take the interest-rate differential but perhaps also profit by an appreciation of the higher-yielding "long" currencies. The reason why we haven't witnessed the classic Carry-Trade of late is that conditions have been the diametric opposite of what is required.

 

The rise of the US Dollar and the higher rate scenario that's largely behind it has been playing havoc with emerging markets with high levels of US Dollar-denominated debt (and their currencies) for some time. More recently, geopolitical turmoil (Italy, N. Korea, Global Trade) has brought on a spike in volatility and "Risk-Off" thinking that has seen money pouring into safe-havens such as the Jap Yen. In other words, if your carry-trade had entailed selling the Yen (which has risen) and buying an EM currency (which has fallen), your foreign exchange exposure would have made the whole experience very painful indeed.

 

But there is a carry-trade that has been performing very nicely, even one that stays within the boundaries of G10 currencies. In this case the "long" currency is of course the US Dollar. We say "of course", but it does seem a little odd to think of the US unit as the destination currency. But these days in terms of interest rates, the Dollar now provides a significantly higher yield than many others of the G10 currencies (think Euro). And in these turbulent times when matters Italian have seen the Euro fall out of favour as a safe-haven, to a large degree its place has been taken by the Greenback.

 

So it's a carry-trade that Bloomberg have identified as last week making its best returns of the year, and we have to get used to the idea of the Dollar as a high-carry (yield) currency. You could argue that this is really just an old-fashioned  "long" dollar story : expansive policies fostering strong growth, tight labour markets boosting wage pressures and the prospect of inflation .... all of which points to higher interest rates. At a time when data elsewhere has begun to stall, particularly in the Eurozone, that alone is enough reason to be long the Dollar however you structure the trade. And it's why the Dollar has rallied so strongly after a poor start to the year. Whether the interest rate differential will continue to work in its favour will probably depend on whether central banks elsewhere can kick-start their own rate normalization process. In more than a few cases that looks to have been temporarily suspended until the data can resume the healthy glow it had last year.

 

Regarding differentials further down the yield curve, things aren't looking quite as cut and dried as they seemed just a short while ago. US 10yr Treasuries yielded 3.13% just the other day (seemingly) and in many eyes were off to the races ... 3.50% and beyond. It didn't pan out that way, largely because of events in Rome. The same panic that saw safe-haven buying of the Dollar saw buying of the ultimate haven, US Treasuries, which of course drove yields lower. Ironic really ..... yields lower but dollar higher. Mind you, 10yr yields won't matter much if Italy kicks off again  --  as it could very easily at some point  if the government squares up to Frankfurt about their fiscal plans. If that happens , the dollar will be bought whatever US Treasuries are yielding, and those with "long" dollar trades will be in clover even as Rome burns.

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