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Markets Ignore Warnings On Lucrative Carry Trades
Dow Jones, February 22, 2007
Central banks and economic planners have a problem that isn't going away: carry trades.
The reason is that it's just about the only way to make money in the $2 trillion-a-day foreign-exchange market.
Borrowing currencies with low interest rates, such as the yen and the Swiss franc, to buy those with high rates, such as sterling and the New Zealand dollar, has become the biggest play in currency trading as foreign exchange has matured into a vibrant asset class of its own.
Central bankers don't like it because it allows the powerful currency markets to artificially boost some currencies at the expense of others, knocking them out of line with economic fundamentals.
Swiss central bank governor Jean-Pierre Roth this week warned that selling the Swiss Franc shouldn't be seen as a one-way bet. If the trade falls out of favor, sparked by a rise in low rates or a fall in the higher rates, the currency markets could over-correct in an ugly unwinding of heavily exposed positions.
Finance ministers from Europe complain that speculative carry positions have artificially boosted the euro against the yen and hurt exports.
The market ignored them.
Bank of Japan's rate hike this week failed to boost the yen. Roth's hint that Swiss rates would soon be hiked failed to support the Swiss franc.
"If you didn't have a yen carry trade on, meaning yen versus the euro or sterling, then really you didn't make money last year," said Glenn Stevens, managing director at Gain Capital Group, a Bedminster, NJ-based firm that offers foreign exchange trading services and runs two currency funds.
"Officials have tried jawboning, but the trade is too darned attractive," Stevens said.
The only real cure will be to close the interest-rate gap between the major currencies as economic performace converges.
For now, carry trades make money. A straightforward long cash position in euro/yen last year would have generated a gain of over 12.5%. And the gap in interest rates earned around 2.5% to 3% extra.
And even though the euro/yen rate is climbing well into the territory of a speculative bubble, many in the currency markets are relaxed about it.
"We don't share concerns that the carry trade is a crowded phenomenon," said Paul Mackel, a currency strategist at HSBC in London.
"A lot of people try to compare the current situation to what happened in 1998 (when a huge carry unwind pushed the dollar 20 yen lower), but then the FX markets were much smaller, and now many more positions are hedged," said Mackel.
"All of the three low-yielding currencies - the yen, the Swiss franc, and the Swedish krona, are struggling. That still tells the story that they will continue to struggle. There would have to be an unexpected event that made the market reassess risk in general to shake that. It's hard to predict that, so you may as well go with it," he added.
Indeed, while they're earning carry on top of currency appreciation, investors are prepared to tolerate quite large currency moves against them before they close their trades.
"Euro-yen can go down by four big figures before it hurts," said Stevens at Gain.
"You have the hedge funds and the prop guys who think 'I'm earning the carry while I wait, so wake me up when it goes below Y155'," he said.
But that's not the only reason why many funds are hooked on carry; most of funds' other supposedly reliable strategies are simply stuck.
The big short dollar trade, which created the fortunes of many a currency trader from 2002 to the end of 2004, has failed since then, making life very difficult for trend-following macroeconomic funds.
Short-term trading models, like the ones that Gain uses, generally ended up flat for 2006, which is respectable, if not impressive while US Treasurys can offer 5.25%.
And the niche strategy of trading options has been tough while volatility in the currency markets has been low.
So that all leaves currency funds as a whole posting anemic, generally flat, returns for 2006 as they scramble to fill the hole that trend-following strategies have left. Using carry is one way to do that.
"One shouldn't complain about the currency markets," said Thanos Papasavvas, head of currency management at Invesco in London, where he has recently set up a new, aggressive forex fund.
"Currency managers were focused on trend strategies from 2001 to 2004, when there were some very clear trends in place. When that stopped, currency managers didn't adapt quickly enough," he said. Hence the industry's poor returns.
"I think currency managers learned from that," he said.
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