Once upon a time, the FX markets were easier to trade. Currencies traded on their macroeconomic fundamentals, unimpeded by politics and unconventional monetary policy. The carry trade was king.
"In the glory days of carry, the FX market had the luxury of a clear framework for understanding and trading currencies," reminisces HSBC in a report last month, entitled The new era for FX. With interest rates gravitating towards zero, FX markets are now reacting to the far more ambiguous implications of quantitative easing.
The HSBC report says there is now considerable debate as to what QE means for a currency. Indeed, the implications of QE for currencies have not been uniform – they have become based on market perceptions, rather than some mechanistic link.
"Prior to ZIRP [zero interest rate policy], it was more important that carry was linked to a known transmission mechanism – one we understood, rather than the returns from carry itself," states HSBC.
The report then sets out to explain how the move from conventional monetary policy to unconventional QE has created an unclear and complex picture for the FX market. While initially many thought QE was currency negative, in reality it is more mixed. For instance, QE has proved to be US dollar negative, euro positive, sterling neutral and mildly positive for the yen.
In conclusion, given such a mixed picture, equities, not FX, now provide a much cleaner mechanistic link between a given view and a price, says HSBC.
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| Jessica James, head of the FX quantitative solutions group at Commerzbank |
So is the carry trade dead? Don’t be too hasty in writing off the carry trade just yet, says Jessica James, head of the FX quantitative solutions group at Commerzbank.
In a report published last month on the G10 carry trade – which runs with the subtitle Reports of the death of G10 carry are at least somewhat exaggerated – the German bank conducted a study of all 45 G10 currency combinations. It found that G10 currency performance had been broadly similar to typical historical performance, such as was seen between 1990 and 1992, 1993 and 1995, and 1998 and 2002.
What might partly explain the declining interest in the carry trade is that returns in the lead-up to the beginning of the financial crisis in 2007 were exceptional, largely driven by spot moves rather than interest-rate differentials.
"Looking past the favourable spot-rate developments, it is also evident, however, that steady broad-basket carry trade profits can be accrued, even when rate differentials are relatively low," writes James.
Since the second quarter of 2009, the unleveraged G10 carry trade returned 4.9% in dollar terms and 9.4% in euro terms. The group also notes that average rate differentials around the turn of 2012 were only 0.25 percentage points lower than was the case immediately before the financial crisis.
So why all the fuss?
According to Daragh Maher, one of the authors of the HSBC report, the changing dynamics of FX markets mean investors need to understand that factors other than carry might be dominating these trades.
"You have to identify that what you’re playing isn’t necessarily carry," he says. "In many instances, you’re taking a view on risk. And while investors might still be garnering a return from carry, there is greater volatility now – and so volatility-adjusted returns look less attractive."
He cites the example of Australian dollar-yen, one of the best-performing carry trade currency pairs, as an example of this. The AUDJPY has continued to do well. However, much of that is attributable to the risk-on trade.
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"The reason is that these currencies are looking outward [beyond domestic macro-fundamentals] for a lot more of their impetus," says Maher. Commerzbank does concede that macroeconomic data developments have taken a back seat to QE, making risk-adjusted returns difficult to predict and therefore giving some investors cold feet. However, current returns from the carry trade need to be put into context.
Commerzbank’s analysis indicates that returns since the crisis have been especially poor, and negative in most cases when a particular cross-rate is influenced by the policy of two of the central banks conducting QE – the Federal Reserve, Bank of England, European Central Bank, Bank of Japan and Swiss National Bank. However, it points out that a sharp differentiation between central bank policies has enhanced risk-adjusted returns in some cases.
Risk-adjusted returns in Swedish kronor, Norwegian kroner, Danish kroner, Canadian dollars and Australian dollars since 2009 have, in some instances, been higher than has been the case in the long run. It is clear, however, that given the actions of central banks, there has been a reduced universe of available carry-trade pairs.
Based on a carry basket that chooses the three highest-yielding currencies versus the three lowest-yielding currencies, Commerzbank found that, as at the end of the second quarter, the carry basket consisted of Australian dollars-Swiss francs, yen-Norwegian kroner and US dollars-Swedish kronor for seven consecutive quarters.
Since 1990, there has been only one other occasion when the basket went unchanged for longer than five consecutive quarters: 1997.
