Since the start of October, currency markets have shifted quickly to a pro-carry, low-volatility risk-on phase, with FX volatility falling to near historically low levels.
In addition, equities have outperformed other asset classes, with option market pricing of risk looking complacently low to some.
As can be seen from the graph below from Credit Suisse, the swing in risk appetite has resulted in outperformance by carry and growth investment styles by FX investors since the end of September.
The reasons for the outperformance are simple, according to Credit Suisse.
Growth has prospered because the recent rise in global purchasing managers’ activity surveys signals an improved environment for industrial production momentum for the next few months.
| Carry has outperformed in October |
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Carry, meanwhile, has benefited because the market can now safely price the Federal Reserve’s monetary policy to be on hold in the near future, allowing investors to continue to target higher-yielders, such as the Australian and New Zealand dollars, as well as emerging market (EM) currencies.
Indeed, that prospect was heightened on Tuesday as weak US jobs numbers pushed back expectations of when the Fed would start to taper the asset purchases in its quantitative-easing (QE) programme.
The prospect of a period of weaker US data, perhaps exacerbated by the recent government shutdown, therefore reinforced the belief that QE3 from the Fed will be around for some time to come. That – combined with low FX volatility – emboldened carry-trade investors to sell the low-yielding dollar and yen to fund the purchase of higher-yielding currencies.
| FX implied volatility has fallen |
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However, some warn against complacency.
Morgan Stanley’s positioning tracker suggests the market is short the yen and neutrally positioned on the dollar.
Hans Redeker, head of global FX strategy at Morgan Stanley, says lower US bond yields and bond volatilities might suggest seeking high-beta investment in carry trades.
“While this strategy has worked over the past few weeks, there is a storm brewing in China which is likely to create volatility, pushing investors from high-beta [currencies] into low-beta [currencies], with the yen likely to benefit the most,” he says.
Worries about China have been fanned by reports suggesting the country’s four largest banks are increasing their debt write-offs from Rmb7.65 billion to Rmb22.1 billion in the first half of the year.
Signs that China is looking to restructure after the aggressive lending witnessed from 2009 onwards have also been seen in the money market.
The People’s Bank of China (PBoC) pushed the renminbi’s daily fixing against the dollar up an aggressive 65 basis points to a 20-year high on Wednesday, while the benchmark renminbi money-market rate rose the most since June to 3.78%.
In addition, the PBoC suspended reverse repos instead of adding funds to the market, indicating a leaning towards tightening.
The tightening from the PBoC comes amid reports of record inflows of hot capital into China, as banks revealed an increase of their FX positions and as house prices in the country continue to soar.
The action from the Chinese authorities has, unsurprisingly, weighed on local stocks.
“Monetary authorities pushing money-market rates and the renminbi higher indicates that the country is heading towards consolidation and restructuring, which in the long term is not a bad thing, but would cost growth now,” says Redeker.
He believes the yen should be the ultimate winner if equity market weakness spreads from China to other markets. That is because Japanese banks are the world’s number-one cross-border lenders, suggesting the “new yen” will trade like the old dollar”.
“When investors take risk off, the related reduction of funding positions leads towards yen repatriation flow,” says Redeker.
He believes China could be a game-changer for the carry trade, potentially triggering a repeat of events in May and June, when the renminbi rallied and renminbi money-market rates went up sharply, creating an EM growth scare.
For those that are more sanguine about China, there are other reasons to be wary over carry trades.
George Saravelos, strategist at Deutsche Bank, says despite the weak US jobs report, going long carry trades is easier said than done.
First, he says, carry is extremely expensive.
Deutsche measures valuation in FX through purchasing power parity (PPP). As can be seen from the chart below, the deviation from PPP of a basket that is long the top-three yielding G10 currencies versus the bottom-three yielding G10 currencies is close to 20%. In the past, that 20% level has been an extreme that has been associated with sharp drawdowns in carry-trade strategies.
| PPP extremes not good for carry |
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Second, Saravelos notes, the market is already priced for what he describes as “exceptionally boring” activity for the rest of the year.
After all, volatility across rates, FX and equities is close to year-lows, while the market is pricing June 2016 Fed funds at 1.1%, 40bp below median Fed projections.
Thus, says Saravelos, extended valuations and low volatility means that the leverage required to generate the same unit of carry-trade return is high, making the eventual build-up in positioning and risk of unwind even greater.
“Putting one and two together, jumping on an indiscriminate carry bandwagon doesn’t seem like a good idea,” he says.
Famously, the propensity for carry trades to unwind spectacularly has seen the strategy likened to picking up dimes in front of a steamroller. The danger now is that the steamroller could start to accelerate.