Profiting From Carry Trades And Interest Rate Differentials

Profiting From Carry Trades And Interest Rate Differentials – The U.S. Dollar and Euro banknotes can be seen in this photo taken on July 17, 2022. /Dado Ruvic/Illustration Acquire Licensing Rights

LONDON/SINGAPORE, July 26 () – A slide in the dollar and signs of returning volatility in foreign exchange markets as interest rate hikes are causing investors to re-evaluate the ever-popular carry trades and rather choose which currencies they return.

Profiting From Carry Trades And Interest Rate Differentials

The carry trade – an investment strategy that takes advantage of differences in borrowing costs between countries – has delivered bumper returns this year as most central banks have raised rates, causing the of yields, but at different rates.

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“The world’s favorite carry trade,” according to Bank of America, involves investors borrowing Japanese yen where the central bank has pegged low rates, and converting them into Mexican pesos to buy higher yield bonds.

One-year bond yields are around 0.1% in negative territory in Japan , but their Mexican counterparts are yielding around 11%.

A hypothetical $50,000 invested in a short yen, long peso carry trade for the first six months of the year would yield a profit of $15,100, according to Refinitiv Eikon.

“Carry is very focused in the first half of the year,” said Kamakshya Trivedi, head of global FX, rates and EM strategy at Goldman Sachs. “Something like 70% of the cross section of moves (in EM currencies) can be explained by the carry.”

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Deutsche Bank’s emerging market carry strategy index had its best year on record in the 12 months to May.

But trading could be jolted this week as the Federal Reserve, European Central Bank and Bank of Japan set interest rates and provide clues on the monetary policy outlook.

“You have to worry about some of these tighter positions,” said Stephen Gallo, European head of FX strategy at BMO Capital Markets.

Gallo said a pick-up in market volatility or a drop in EM interest rates could trigger a rush for exits.

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James Athey, director of investment at abrdn, said: “Things like the Mexican peso have been positioned for a long time, it’s more like you’re taking pennies in front of a steamroller.”

Volatility is important, as an appreciation in the currency in which investors borrow, or a reduction in the one in which they invest, can wipe out profits from yield differences.

The yen hinted at snapping back, firming from 145 per dollar to 137 in the first half of July.

“I think that’s enough to offset any carry trade profits,” said Yujiro Goto, head of FX strategy for Japan at Nomura.

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Volatility has been low this year because most central banks have raised interest rates in tandem and there has been little damage to the global economy, said Oliver Brennan, FX volatility strategist at BNP Paribas.

Today, things look different: the Fed looks set to pause, the Bank of England still has ground to cover, some emerging market central banks are considering cuts, and the Bank of Japan is keeping traders guessing.

Volatility in the world’s five most-traded currencies fell to its lowest in a year and a half in June, according to CME Group’s options-based volatility gauge, but has since edged higher.

Emerging markets are not the only focus. Investors also flocked to higher U.S. bond yield compared to many countries by “long” in the dollar.

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However, the greenback fell 2% against a basket of major currencies this month, after a sharp slowdown in U.S. inflation. in June raised hopes that the Federal Reserve was nearing its final interest rate hike.

This “benign disinflation” in the U.S. could help dollar-funded emerging markets continue to perform well, said Robin Winkler, FX strategist at Deutsche Bank.

“In the G10, however, the negative USD turn is not necessarily positive for carry, seeing as the USD is a favored long,” he said.

“In particular, the Japanese yen, but also the Swiss franc and Swedish or Norwegian kroner, have been used as funding currencies for the long term of the USD,” he said. “As a result, these USD pairs have come under intense pressure.”

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A hypothetical $50,000 invested in a short Norwegian crown, long dollar carry trade in the first three weeks of July would lose $3,000, according to Refinitiv.

Goldman’s Trivedi said the carry trade could still reap rewards, especially if emerging markets are boosted by Chinese stimulus. He recommends not just picking the highest-yielding currencies, however.

“Adding currencies that have a lot of cyclical exposure makes sense, given a world where growth is going to be stronger… that includes things like the Brazilian real in Latin America or the Korean won in Asia.”

“Just be selective right now,” he said. “You just don’t want to double up, or triple up, on risk exposure.”

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Reporting by Harry Robertson and Alun John in London and Ankur Banarjee in Singapore; additional reporting by Rae Wee in Singapore; Editing by Bernadette Baum Trading strategies refers to a set of techniques and strategies that traders use to make informed decisions about buying, selling, or holding financial assets such as stocks , bonds, commodities, or currencies.

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