Saqib Iqbal Ahmed
NEW YORK (Reuters) – An unusual calm gripping currency markets is extending the life of lucrative trading beyond what many expected.
The so-called “carry trade”, which involves borrowing in a low-interest rate currency to invest in a higher-yielding currency, was expected to disappear as major central banks steer away from raising rates in favor of easing policy.
However, there has not yet been a major shift that will keep currency markets calm and trade that relies on such stability an easy win.
“The carry trade is often referred to as picking nickels before the steamrollers, but last year speculators were collecting stacks of $100 bills,” said Carl Sciamotta, chief market strategist at payments company Corpay.
“Profits trump almost everything else.”
This strategy provided incredible profits for those who played correctly, Corpay reports. Global payments (NYSE:) analysis showed. Buyers of the high-yielding Mexican peso who sold the Japanese yen would have made a gain of about 44% over the past 12 months. Other popular carry currencies have also delivered similarly huge gains.
The Deutsche Bank index, which includes elements that include the portability of 21 emerging market currencies, rose 6.6% in 2023, its best year since 2017. The Equally Weighted Total Return DB EM FC Index, as it is called, rose almost 1%. for the last month.
However, the situation may change. Lower inflation in emerging markets opens the door for central banks to ease policy in 2024, narrowing the spread between the highest and lowest-yielding currencies.
Mexico recently joined Brazil, Chile and Colombia in cutting rates for the first time since tightening began in mid-2021.
“The carry trade is likely to run out of steam, and while these currencies could see further gains, the tailwinds that propelled them to big gains in 2023 appear to have run their course,” said Jonathan Petersen, senior markets economist at Capital Economics.
Last week, Fed policymakers said they still expect to cut rates by three-quarters of a percentage point by the end of 2024. However, the Fed and European Central Bank are unlikely to match the scale and speed of policy easing in emerging markets.
As a result, carry traders should be more discerning, says Aaron Hurd, senior foreign exchange portfolio manager at State Street (NYSE:) Global Advisors.
“This is not a very clear situation that has developed over the last year and a half,” he said. “Overall we are moving in a more cautious direction…trying to do higher quality or lower risk carry trades now.”
Hurd is moving away from using the yen as a funding currency, saying it is vulnerable to a sharp move towards the stable Swiss franc. He prefers to buy Indian Rupee while selling 0.000.
VALATILITY IS KEY
Synchronized actions by central banks have helped curb interest rate volatility. The Deutsche Bank CVIX Index, a weighted average of the expected volatility of nine major currency pairs, recently fell to near a two-and-a-half-year low.
This means that investors are not ready to abandon carry trades anytime soon.
“I think markets were expecting January or February to be more volatile months, when we would see a decline in US data, which would perhaps justify the Fed cutting rates as early as March or May,” said Francesco Pesole, foreign exchange Strategist at ING in London. . Instead, he noted that there were strong two months of data from the US.
“We could definitely see a few more weeks of carry remaining relatively popular,” Pesole said.
Despite notable interest rate moves over the past few weeks, including a surprise rate cut by the Swiss National Bank and the Bank of Japan’s long-awaited move away from negative interest rates, volatility remained low.
Three-month implied volatility of the dollar versus the yen, a measure of the value of options contracts that traders use to hedge positions, was near its lowest level in about three months.
However, according to analysts, it will not take much time to roil the markets and shake up the carry trade.
“It’s very difficult to imagine that the currency markets will become even calmer,” said Petersen of Capital Economics.
Surprises could come from central bank policy actions, economic data, geopolitical turmoil and elections around the world this year, including in the United States, he said.
“The bottom line is that the bar is very low for volatility to go higher from here.”