Hoorah ! The Carry Trade is back ...... but be quick or you might miss it.

Wednesday 23rd March 2016

Hoorah ! The Carry Trade is back ...... but be quick or you might miss it.

ref :- "Short View" by Roger Blitz, the Financial Times

Just for a moment we're going to leave aside the question we've been pondering for the last couple of days, i.e. is the US Fed's newly-stated doveish position on rates (two hikes this year rather than four) sustainable, desirable or even totally sincere ? Like most of the market up to now, let's assume it is.

You wouldn't have thought it possible just a few weeks ago when all markets (and particularly Foreign Exchanges) were in turmoil, but the Fed's forecast for a slower pace of rate hikes (and their accompanying rhetoric) has restored calm. And low volatility + stable currencies + still significant interest rate differentials  

= a suitable environment for carry trades.

For newcomers, a quick recap on the basics of the carry trade, or at least one type of such an animal :

Borrow Currency A for a set period AT A LOW RATE  >>>>>  Sell Currency A, Buy Currency B  >>>>>  Lend Currency B for the same period AT A HIGHER RATE  >>>>>  At the end of the period, Sell Currency B, buy back Currency A  >>>>>  Repay original loan in Currency A.

For such a strategy to work you need a stable foreign exchange rate between the two currencies, and guess what we've got now all of a sudden ? Largely thanks to the Fed's new stance, stability. Emerging markets, where generally higher interest rates make the currencies perfect candidates for the role of Currency B, have indeed staged something of a rally and the US dollar has actually lost ground when most forecasters at the start of the year saw interest rate hikes in the States continuing to push it higher. Nevertheless, it seems to us that it's asking quite a lot of traders so badly burnt by the unexpected devaluation of the Chinese Yuan last August to pile back in.

There are numerous reasons why things might change dramatically  --  you might also say, quite correctly,  there are just as many reasons why they won't but we're trying to identify some pitfalls here. Will the political chaos in leading emerging market Brazil undermine confidence in the whole sector ? Can anybody really be confident in China's prospects (and indeed, its actions)? And to go back to the issue we were leaving aside  --  it really is unavoidable  --  do we believe that the Fed's new softly, softly approach will turn out to be the reality ?

To answer that last question, you have to decide whether in the face of continuing growth and rising inflation would the Fed really be prepared to forego their dual mandate (controlling employment and inflation) and base its actions on the wider global context. As we discussed yesterday, Goldman Sachs for one do not buy into that scenario.

So yes, conditions for the carry trade have returned but the dangers attached haven't really gone away. From this angle, it doesn't look overly tempting.