The carry trade evolves

IN A world where quantitative easing remains firmly on the agenda and investors are going after any yield available, the carry trade remains alive and well. Further accommodative monetary policy in Japan has driven the resurgence of the yen carry trade – whereby investors fund higher-yielding asset purchases with low-yielding yen. Furthermore, the latest weakening in the US dollar over recent months, coupled with market speculation that the Federal Reserve will resume QE in November, has kept the dollar-funded carry trade going.

The original carry trade was to sell Japanese yen and buy Aussie dollars. The Aussie, thanks to its commodity characteristics and relatively high interest rates, retains its appeal. But currency traders’ search for FX alpha has widened out beyond the G10 putting the spotlight on emerging currencies like the Brazilian real that also offers the combination of relative yield and commodity characteristics, says Philip Poole, global head of macro and investment strategy at HSBC Global Asset Management.

Poole does not see this shift as temporary: “There is more to this than short-term carry-related return characteristics. High FX reserves held by emerging countries have increased policy credibility. As private sector investment into emerging markets has risen the capital inflows have put upward pressure on currencies.”

“Moreover, it can be expensive to hedge underlying investments in these markets and this has had a positive impact on currencies. Domestic investors also now have greater faith in domestic macro conditions and their own currencies,” he adds.

Rising interest rates to combat inflationary pressures should also contribute to the positive interest rate differential between emerging market currencies and the developed world. Rate hikes in both India and Chile have confirmed this trend and analysts expect the cost of borrowing to rise further in countries such as South Korea, India, Indonesia, Philippines and Taiwan before the end of the year.

There is certainly further upside to emerging market FX, says Societe Generale strategist Benoit Anne, who believes that EM currencies are still quite undervalued. He is positive on the Mexican peso, which is down almost 20 per cent on its pre-crisis level, despite the risks related to the US macro conditions, and on the South Korean won, owing to the country’s strong macro performance.

FX traders should not dismiss the continuing value of the carry trade, especially when developed market central banks such as the Federal Reserve, the Bank of Japan and even the Bank of England are actively considering further asset purchases.