Although the carry trade label means slightly different things to different players, it is essentially the process of capturing the yield differential between low-yielding and high-yielding currencies, often using the proceeds to buy more higher-yielding assets, such as emerging market (EM) securities.
As a rather effective and liquid way of generating leverage, it is a firm favourite of hedge funds and commodity trading advisers around the world.
Most of these players are now nursing substantial FX losses from a brutal summer, which has seen some of the key carry trade underpinnings massacred. Some managers say this year’s losses are worse than those suffered during the financial crisis.
“The unwinds of the summer put the carry trade losses of 2008 into perspective,” says Robert Savage, chief strategist at FX Concepts, a currency-focused hedge fund. “The downside move has been ferocious and bigger than anything we saw during the financial crisis. Year-to-date, the 30 or so currencies that are used in the carry trade are down 33%.”
For example, carry trade classic AUDJPY is down by 10% since the end of May, although a lot of the downside in the Aussie dollar is related to the Reserve Bank of Australia’s aggressive interest-rate cuts over the summer, which have lowered AUD yields to an historic low of 2.5%. By comparison, Aussie dollar interest rates spent most of 2008 above 7%.
However, taken over the year, AUDJPY is only down by 2.69%. The pain has been worse in developing market currencies such as the Brazilian real, Indian rupee and Turkish lira.
“AUDJPY has been a very big part of the unwind story, but it’s not the whole story,” says Savage. “AUDJPY has been falling all year, but there are plenty of other currencies involved.”
However, the traditional carry trade analysis, which has focused on interest-rate differentials, is being impacted by the rise in FX spot volatility during the past few years. Investors who bought into the carry trade on the basis of the traditional analysis could find themselves suddenly run over.
“Interest-rate differentials have actually been much more stable than people want to admit, and have been consistent at around 5% to 6% over the past decade,” says an FX trader.
“The noise that’s disrupting the carry trade this year is coming from the spot market. EM currencies began the long-term appreciation trend in 2003, which was reinvigorated in 2008.
“Since then, we have seen governments become increasingly interventionist, which we see in BRL, INR and TRY. The currency spot component is what lost money this year.”
While tapering chatter can be seen as government intervention without the open market operations, other factors, particularly derivatives regulations, are impacting currency-market volatility, especially in the EM and frontier currency pairs that are so important for traders seeking to profit from FX carry.
Although critics of the Volcker rule say that dealers are reducing risk appetite in response to the proprietary trading ban, Title VII of Dodd-Frank is reducing US banks’ market appetite across derivatives markets, including FX.
“US banks are less willing now than they have ever been to take overnight risk, and the amount of risk they are holding is going down,” says an FX trader. “Options, NDFs and anything that requires margin has less US bank interest.”
As some managers try to distance themselves from the carry trade, claiming that intervention has rendered the play to unpredictable, the negative performance of the CTA sector this year suggests many are still involved.
“I don’t care who it is, the carry trade is an important part of FX beta and the fact that it has blown up is a huge problem,” says Savage.
Just a day’s extreme currency movements is enough to wipe out traders’ gain over the year and second-guessing global central banks’ policy moves is proving a foolhardy endeavour.