By Saqib Iqbal Ahmed
The Unexpected Continuation of a Lucrative Trade
NEW YORK, March 27 (Reuters) – Despite initial projections of its demise, the foreign exchange markets find themselves in a peculiar state of tranquility, prolonging the viability of the lucrative carry trade beyond expectations.
The carry trade, a strategy involving borrowing in a low-interest-rate currency to invest in a higher-yielding currency, was anticipated to wane as major central banks shifted from rate hikes to easing their policies.
However, the anticipated shift has not materialized, maintaining stability in currency markets and allowing the carry trade, which thrives on such stability, to remain a winning strategy for investors.
“Comparing the carry trade to picking up nickels in front of steamrollers seems like an understatement, as speculators have been collecting bundles of $100 bills over the past year,” remarked Karl Schamotta, chief market strategist at payments company Corpay.
“The returns are surpassing virtually all other investment options.”
An analysis by Corpay Global Payments indicated that investors who bought the high-yielding Mexican peso and sold the Japanese yen could have seen gains of approximately 44% over the last year. Similarly, other popular carry currencies have also delivered substantial returns.
Deutsche Bank’s index, which tracks the performance of the carry trade of 21 emerging market currencies, surged by 6.6% in 2023, marking its most successful year since 2017. The index, known as DB EM FC Equally Weighted Total Return, has continued to climb, registering nearly a 1% increase over the past month.
Impending Winds of Change
Nevertheless, there are signs of a potential shift on the horizon. Decreasing inflation rates in emerging markets are paving the way for central banks to ease their policies in 2024, thereby narrowing the interest rate differential between high and low-yielding currencies.
Recently, Mexico joined countries like Brazil, Chile, and Colombia in cutting interest rates, marking its first easing move since tightening policies in mid-2021.
“While the carry trade may still show some momentum, the favorable conditions that propelled significant gains in 2023 seem to be fading,” expressed Jonathan Petersen, senior markets economist at Capital Economics.
Last week, Federal Reserve policymakers hinted at a potential 0.75 percentage point rate reduction by the end of 2024. However, the Fed and the European Central Bank are unlikely to match the scale and speed of easing witnessed in emerging markets.
As a result, carry traders are advised to be more discerning in their investments, shared Aaron Hurd, senior portfolio manager, currency, at State Street Global Advisors.
“The environment isn’t as clear-cut as it was over the past year and a half. We’re now moving towards a more cautious approach, focusing on higher quality or lower-risk carry trades,” he explained.
Volatility as the Decisive Factor
The synchronized movements of central banks have contributed to curbing interest rate volatility, as indicated by Deutsche Bank’s CVIX index, a measure of projected volatility across major currency pairs, reaching a near 2.5-year low.
This prevailing low volatility suggests that investors are not yet ready to abandon the captivating carry trades.
“There were expectations of increased volatility in January or February, with a potential decline in U.S. data prompting Fed rate cuts in March or May,” noted Francesco Pesole, forex strategist at ING in London. However, robust U.S. data during those months defied those expectations.
“We could foresee a few more weeks with carry trades remaining popular,” Pesole added.
Despite recent notable interest rate adjustments, including a surprising cut by the Swiss National Bank and the Bank of Japan’s transition away from negative interest rates, volatility has remained subdued.
The three-month dollar/yen implied volatility, a gauge of the cost of options contracts used for hedging, is hovering near its lowest point in approximately three months.
Although the markets appear calm, analysts caution that any unforeseen events related to central bank actions, economic data, geopolitical disruptions, or global elections could disrupt the carry trade.
“It’s difficult to envision currency markets becoming even more tranquil,” remarked Petersen of Capital Economics.
“The potential for surprises remains high, making it easy for volatility to surge from its current levels,” he concluded.
Carry on https://reut.rs/3IJgRDd
(Reporting by Saqib Iqbal Ahmed; Additional reporting by Laura Matthews; Editing by Megan Davies and Richard Chang)
(([email protected]; @SaqibReports; +1 332 219 1971; Reuters Messaging: [email protected]))
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
