Carry Trade

Dollar rallies as carry trades unwound

By Steve Johnson and Peter Garnham

Published: May 15 2006 12:04 | Last updated: May 15 2006 17:51

The beleaguered US dollar staged a comeback on Monday as carry trade investors scrambled to exit a swathe of dollar-funded positions amid a spike in risk aversion.

The dollar rally came despite a report showing US capital inflows in March were lower than expected at $69.8bn. However, the news was widely ignored as traders reasoned that capital inflows, though below forecasts, were still sufficient to cover the US monthly trade deficit.

Instead, the dollar benefited from the closure of a raft of leveraged speculative trades against emerging market currencies as global equity markets extended last week’s sell-off, and commodity prices also headed sharply lower.

Short-dollar positions against a number of other currencies, such as the yen, euro and sterling, were also cut amid profit-taking, after the trade-weighted dollar fell to its lowest level since October 1997 on Friday. Data released over the weekend showed net short-dollar positions in the currency market were at their most extreme since November 2004.

“The biggest positions at risk, long emerging market equity, long commodities and long currency, are all funded out of short-dollar positions,” said Steve Pearson, chief currency strategist at HBOS.

As a result, the dollar rebounded 0.7 per cent to $1.2840 against the euro by mid-afternoon in New York, 0.5 per cent to $1.8840 against sterling, 0.8 per cent to SFr1.2080 against the Swiss franc and 0.4 per cent to C$1.1124 against its Canadian namesake.

The yen was also broadly strong, easing just 0.1 per cent to Y110.16 against the dollar and firming 0.7 per cent to Y141.38 against the euro, 0.4 per cent to Y207.45 against sterling and 0.9 per cent to Y84.18 against the Australian dollar, with the liquidation of yen-funded long-gold positions a factor, as well as continuing talk that the Bank of Japan could start its rate-tightening cycle as early as next month.

The Chinese renminbi was also allowed to breach the psychologically important Rmb8 barrier against the dollar for the first time since January 1994 in over-the counter trade, before closing a fraction higher at Rmb8.0030.

However other emerging markets continued their sell-off amid the rise in risk aversion. Increasing volatility among the major currencies has reduced the attraction of borrowing in these currencies to fund emerging market positions, as has rising interest rate expectations in Japan, the eurozone and Switzerland.

“The sharp rise in financial market volatility accompanied by an increase in risk aversion has triggered an unwinding of emerging market carry trades, putting the higher-yielding emerging market currencies under pressure,” said Hans Redeker, head of currency strategy at BNP Paribas.

The Turkish lira fell 6.1 per cent to TL1.4850 to the dollar, the South African rand 3 per cent to R6.4255, the Polish zloty 1.9 per cent to 3.0630, the Icelandic krona 0.5 per cent to IKr71.23, the South Korean won 1.1 per cent to Won943.40 and the Indonesian rupiah 3.7 per cent to Rp9,100.

The Australian and New Zealand dollars, other high-yielding beneficiaries of yen-funded carry trades, fell 1 per cent to $0.7644 and 1.3 per cent to $0.6215 against the greenback respectively

As in previous episodes of emerging market weakness, the sell-off was said to be partly driven by carry trade investors needing to close some profitable positions to fund losses in others that are turning sour.
>■Trading volumes on the EBS foreign exchange dealing platform hit a record $235bn last Friday. This compares to average daily volumes of $130bn and means the busiest month, week and day on the system have all taken place on the first half of 2006.
3d sempre di attualità....qui condito con
un pò di sana teoria economica..
Economics focus

Carry on speculating
Feb 22nd 2007
From The Economist print edition

How traders have been triumphing over economic theory

NO COMMENT on the financial markets these days is complete without mention of the “carry trade”, the borrowing or selling of currencies with low interest rates and the purchase of currencies with high rates. The trade is often blamed for the weakness of the Japanese yen and the unexpected enthusiasm of investors for the New Zealand and Australian dollars.

But why does the carry trade work? In theory, it shouldn't—or not for as long as it has. Foreign-exchange markets operate under a state of “covered interest parity”. In other words, the difference between two countries' interest rates is exactly reflected in the gap between the spot, or current, exchange rate and the forward rate. High-interest-rate currencies are at a discount in the forward market; low-rate currencies at a premium.

If that were not so, it would be possible for a Japanese investor to sell yen, buy dollars, invest those dollars at high American interest rates for 12 months and simultaneously sell the dollars forward for yen to lock in a profit in a year's time. The potential for arbitrage means such profits cannot be earned.

However, economic theory also suggests that “uncovered interest parity” should operate. Countries that offer high interest rates should be compensating investors for the risk that their currency will depreciate. In other words, the forward rate should be a good guess of the likely future spot rate.

In the real world, uncovered interest parity has not applied over the past 25 years or so. A recent academic study* has shown that high-rate currencies have tended to appreciate and low-rate currencies to depreciate, the reverse of theory. Carry-trade strategies would have brought substantial profits, not far short of stockmarket returns, although dealing costs would have limited the size of the bets traders could make.

Academics have struggled for some time to explain this discrepancy. One possibility is that investors demand a risk premium, separate from the better interest rate, to compensate them for investing in a foreign currency. As this risk premium varies, it might overwhelm the effects of interest-rate changes. For example, American investors might worry about the credibility of the Bank of Japan, but Japanese investors may regard the dollar as a “safe haven”. This would drive the dollar up and the yen down.

However, according to Andrew Scott, of the London Business School, it has been a struggle to find risk premiums that are large enough to explain exchange-rate volatility. So academics have been looking at the structure of foreign-exchange markets, to see if behavioural factors might be at work.

One obvious possibility is that the actions of carry traders are self-fulfilling; when they borrow the yen and buy the dollar, they drive the former down and the latter up. If other investors follow “momentum” strategies—jumping on the bandwagon of existing trends—this would tend to push up currencies with high interest rates.

Financial jaywalking
Such a strategy has its dangers. It has been likened to “picking up nickels in front of steamrollers”: you have a long run of small gains but eventually get squashed. In the currency markets, this would mean a steady series of profits from the interest-rate premium that are all wiped out by a large, sudden shift in exchange rates: think of the pound's exit from the European exchange-rate mechanism in 1992. The foreign-exchange markets have been remarkably calm since the Asian crisis of 1998 (when the yen rose sharply, hitting many carry traders). So a whole generation of investors may have grown up in a state of blissful innocence, unaware that their carry strategy has severe dangers.

Inflation may provide an alternative explanation. The theory of purchasing-power parity (PPP) implies that high-inflation currencies should depreciate, relative to harder monies. In other words, while nominal exchange rates might vary, real rates should be pretty constant. And over the very long term, this seems to happen. A study by the London Business School†, with ABN Amro, a Dutch bank, found that real exchange rates in 17 countries moved by less than an average of 0.2% a year over the period 1900-2006.

Other things being equal (such as roughly similar real interest rates across countries) nominal interest rates should be higher in countries with higher inflation rates. So this should give support to uncovered-interest parity and deter the carry trade. Clearly, though, PPP has not been a useful guide over the past ten years, as the deflation-prone yen has declined against the dollar.

Perhaps the success of the carry trade reflects biases built up in an earlier era, during the inflationary 1970s and 1980s. Currencies prone to inflation back then, such as sterling and the dollar, have had to pay higher interest rates to compensate investors for their reputation. In fact, because inflation has declined, investors in Britain and America have been overcompensated for the risks—a windfall gain that has been exploited by followers of the carry trade. However, it is hard to believe that this effect could have lasted for as long as it has. So the reasons for the success of the carry trade remain a bit of a mystery.

What does seem plain, however, is that the carry trade tends to break down when markets become more turbulent. In such conditions, those who borrowed yen to buy other assets (such as emerging-market shares) might face a double blow as the yen rose while asset prices fell. If the turbulence were sufficiently large, many years' worth of profits from the carry trade might be wiped out. A steamroller could yet restore the reputation of economic theory.

* “The Returns to Currency Speculation”, by Craig Burnside, Martin Eichenbaum, Isaac Kleshchelski and Sergio Rebelo

† Global Investment Returns Yearbook 2007