Investors go back to fundamentals as they lose their taste for carry

IN THE second half of 2009, the dollar-funded carry trade was the primary strategy used to play the foreign exchange markets. The low interest rates set by the Federal Reserve combined with the weakening of the greenback meant that traders were happy to sell low-yielding dollars in search of higher-yielding currencies such as the Australian dollar and the Brazilian real.

But the greenback has surged since the start of 2010 and the carry trade appears, once again, to have lost its attraction. Traders are now trying to anticipate what will happen next and consequently, which strategy will be most profitable.

There have typically been three overarching strategies for trading the currency markets: carry, momentum and valuation. While carry is based on yield, momentum is based on currencies’ trends over time and uses past movements in price to predict future moves. Valuation looks at the currency’s actual value versus the fair value based on purchasing power parity (PPP), a theory which holds that price levels should be roughly equivalent in developed countries.

A recent study by investment bank Deutsche Bank showed that by equally weighting these three strategies in your G10 portfolio and passively following them over the past 30 years – as measured by the Deutsche Bank currency returns (dbCR) index – you would have achieved an average annual return of 3.9 per cent.

The research also indicates that there is a negative correlation between momentum and valuation – currencies which experience positive momentum eventually become overvalued, and vice versa. There is also a flat correlation between carry and momentum – as the long carry currencies become overvalued relative to the short carry currencies, the carry trade loses momentum as investors become concerned about valuations.

While carry had been the dominant strategy in the markets since mid-2009, how likely is this to continue in 2010? There have been signs that the strategy may be starting to lose its momentum – long carry currencies such as the Australian dollar and the New Zealand dollar have returned to being overvalued after having been cheap following the 2008 carry drawdown.

But while some investors may be hesitant to increase their exposure to currencies, especially the carry trade, given the staggering 2009 equity rally and Fed hikes looming on the horizon, the Deutsche Bank report points out that historically, carry has performed well during the past three Fed hiking cycles, especially in the six months preceding the first hike. This would suggest a return, perhaps, to the traditional carry trade of selling yen to buy currencies with higher interest rates.

Ugo Lancioni, executive director of global fixed income and currency management at Neuberger Berman asset manager, says that investors have recently been looking at carry from an interest rate expectations perspective, buying currencies with more aggressive hikes already priced into the market. The positive return delivered by carry in 2009 came mainly from currency appreciation rather than yield advantage. He thinks that interest rate differentials may not yet be wide enough to justify the same carry performance in the coming months, and he believes that fundamental trading strategies are going to perform better than carry and momentum strategies because of the uncertainty in the markets. Range trading is more likely and “momentum does well when you have a clear trend”, he says.

Traders should therefore be looking to buy currencies that are under-valued relative to the dollar such as Russian rouble and the Polish zloty and sell those that are over-valued such as the Aussie dollar and the Swiss franc.