Carry Traders seldom need much encouragement, and doveish talk from the ECB opens windows of opportunity......

Friday 23rd October 2015

Carry Traders seldom need much encouragement, and doveish talk from the ECB opens windows of opportunity......

 Ref : "Draghi Injects New Life Into Euro Carry Trade, Sends Kiwi Flying" , Bloomberg Markets.

You may remember a couple of months ago in the aftermath of the Yuan devaluation we had a look at how the resultant volatility (and emerging market currency weakness) had dealt a blow to one of the staple practices of foreign exchange markets, the carry trade. But just because conditions are difficult and temporarily non-profitable it doesn't follow that the carry trade goes away. Any number of interest rate differentials and foreign exchange rates are constantly monitored, and if opportunities present themselves (and conditions are not too dangerous), they'll be plenty of traders ready to act.

For newcomers, it might be worth reminding ourselves how the carry trade works at the most basic level. For good order's sake, we'll revisit the totally hypothetical and not necessarily wholly realistic example we used back in August :

" A trader might :

Borrow in Currency A at 1.00% for a certain period  --  Sell Currency A, Buy Currency B  --  Lend in Currency B for the same period at 5.00%  --  At the end of the period, Sell Currency B and Buy back Currency A  --  Repay original loan in Currency A.

Thus he has made 4.00% in interest rate differential over the period. The danger is that there is an obvious foreign exchange rate risk that is not easily hedged (without harming profits) : if Currency B weakens during the period, he'll have to pay more to buy back Currency A, which depending on the extent of the depreciation could make the deal a serious loss-maker. So it can be dangerous, particularly as these trades are usually highly leveraged, and has been likened to picking up pennies in front of a steamroller. Relatively stable conditions are required, and volatility is a "No, No" .........."

ECB president Mario Draghi's comments yesterday have left most of the opinion that the ECB will instigate further easing measures in December (in whatever form), and has left the Euro marked sharply lower on exchanges. This has of course alerted those sniffing for opportunities and of the 43 potential carry trades funded by euros and tracked by Bloomberg, all would show a profit in the period since Mr Draghi spoke. The NZ Dollar has been a big beneficiary, although the best return over the last couple of days has in fact been provided by the Colombian peso (not necessarily the vehicle of choice for the more cautious investor).

This is a game of small margins, and strictly one for the professionals who can constantly monitor and act upon exchange rate movements if required. But renewed interest in the Euro carry trade has prompted some to speculate that Jap Yen and US Dollar carries may shortly be back in vogue too as the Bank of Japan is forced to emulate ECB easing and the Fed continues to delay its first rate hike.

 Of course there are two sides to every equation and a big increase in volume for these type of carry trades assumes, if not stable conditions, then at least orderly ones. That of course is a very big assumption right now, but it won't stop traders trying to nick a few bucks where they can.