Measuring the Carry Trade Candidates for 2009 After the Fed Cuts Rates to Near Zero

12/18/2008 11:49 am EST

Focus: FOREX

Interest rates have changed dramatically over the past 12-18 months with the upheaval in credit markets and the onset of a global recession. And, while the resulting plunge in investor sentiment has claimed many casualties along the way, the carry strategy seems to be one of the hardest hit. However, investors will not sit on idle capital for long, and eventually, a turn in sentiment will put investors and banks back on to yield and into the carry trade.

In this article, we will go over the arguments for and against carry, as well as the likely timing for this prolific strategy to regain its place in the market. Then, we will look through the individual currencies and determine which are best suited for playing a funding roll, a carry roll, and those that should simply be avoided.  

Arguments Against Carry

Considering the current level of uncertainty and risk aversion in the market, the carry trade is not an attractive strategy right now. Through past months, the need for liquidity, steady drop in global interest rates, and persistently high level of volatility means that a reversal of the traditional carry trade has been one of the most consistent trends through the developing financial slump. What’s more, as long as all of these conditions are still in place, the risks related to this strategy will outweigh the benefits.

Before banks and the other large pools of capital return to this strategy, a few things will need to happen. First and foremost, credit conditions must improve. Without access to credit, the levels of total capital and leverage will remain severely depressed. Furthermore, the concern this produces for liquidity is one of the primary pillars for the market fear that has led to the unwinding of carry. A natural derivative of liquidity is volatility. As carry is a passive strategy that collects yield differentials, the potential for dramatic fluctuations in the underlying exchange rate means capital losses could be equal to, or greater than, the yield income. Another issue that must be addressed is the outlook for the global economy. As long as growth contracts, net wealth will shrink, and caution will keep investors on the sidelines. All the aforementioned issues involve risk, but for investors, the potential for loss is always balanced out with expected return. Therefore, there must also be the potential for yield income. Ultimately, the lower risk is considered to be, the smaller yield differentials will have to be to encourage investment. So the market will have to find its balance.

Arguments For Carry Going Forward

Given current market conditions, it comes as little surprise that the carry trade is still under heavy selling pressure. However, just like any natural economic cycle, this downswing will come to an end. We have already seen policy makers around the world step in with bailout and stimulus packages aimed at thawing the credit markets, boosting investor confidence, and recharging economic activity. While the momentum behind the unfolding global recession will need to play out in its own time (with financial markets in tow), uncertainty is becoming less of an issue.

The majority of economists and government officials may forecast further contractions through the coming months, but there is a growing consensus that the global recession will bottom out some time in the first half of 2009. When this reversal takes place, investors and banks will no longer be solely focused on capital preservation, and will slowly venture back into the markets in search of return on their idle capital. In the aftermath of the worst downturn in decades, speculative interests will be fully flushed and interest rates will be exceptionally low, meaning volatility will be similarly anemic. This will represent the ideal investment conditions for large pools of capital that are looking for consistent returns and deep liquidity. However, which pairs present the best characteristics to draw in carry interest will depend on the individual characteristics of each currency.

Top Funding Currencies

US Dollar – The US dollar has completely flipped its role in the currency market. Through the first half of 2007, the greenback was a well-known carry currency with a benchmark lending rate that reached as high as 5.25%. Going forward, however, the dollar looks to be the best candidate for a funding currency. At its most recent policy meeting, the Federal Reserve lowered its benchmark lending rate to target a range between 0.00% and 0.25%. This is essentially a Zero Interest Rate Policy (ZIRP) without the stigma of being considered such. For the carry trader, this represents free money—a situation similar to Japan between 2001 and 2006 during the long boom in the carry speculation. Beyond bare bones interest rates, the more important foundation for the dollar’s funding status is the commentary by the Federal Reserve statement suggesting the federal funds rate would likely be held at “extraordinarily low levels” for “some time.” Another benefit of borrowing in the US (and shorting the dollar) is deep liquidity. This means that in the next wave of unwinding, there will be little trouble in offsetting positions with minimal loses.

Japanese Yen – With a stable benchmark lending rate at 0.30% and ample capital, Japan is another obvious choice for a top funding currency. The yen was the backbone in the carry trade’s rally to new record highs through 2007. The currency’s characteristics have changed little since then. In fact, the Japanese unit may have further proven itself as an ideal funding currency in the interim as the benchmark lending rate changed very little in over a decade. For the carry trader, this means a consistently growing yield differential when global interest rates start to turn higher, as the Japanese target will likely hold steady while its international counterparts rise.

Swiss Franc – Like the Japanese yen, the Swiss franc was one of the primary funding currencies through the last carry trade build up. Going forward, its appeal has only improved. From a peak of 2.75%, the Swiss National Bank has pursued an easing policy that has lowered the benchmark lending rate to 0.50%. What’s more, there is abundant liquidity to build up a carry base, as the safe haven economy is known to house the world’s capital. However, unlike the US and Japanese rates, there is a higher probability of fluctuation in the Swiss’ main rate going forward.

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Top Carry Currencies

Australian Dollar – In looking for the best currency to take advantage of the eventual rebound in carry, we need to look for already established returns and a promising economic outlook. The Australian dollar meets both of these requirements. Currently, its benchmark is at 4.25% after a series of sharp rate cuts. However, statements and commentary that have followed the rate decisions are backing off the dovish rhetoric and raising expectations of a neutral rate stance in the near term. Even a reduced pace could keep the benchmark lending rate well above that of the US, Japan, or Switzerland. Another attractive trait that the Australian dollar possesses is a relatively strong economy. Australia is the primary commodity provider for Asia, and domestic demand is still fairly stable.

Euro – The antithesis of the US dollar, the euro, holds a unique position among the potential carry currencies. From an interest rate perspective, the European Central Bank has been one of the most reserved policy groups in lowering its target rate. More importantly, officials have suggested further easing will come at a much slower pace. And, while the European benchmark rate does not have as much yield potential as its Australian counterpart, the stability of their monetary policy and the bank’s focus on inflation puts it on a solid foundation.

New Zealand Dollar – Just a few years ago, the New Zealand dollar was the premier carry currency, with a benchmark interest rate that was unprecedented among the G10 at 8.25%. However, backed by a very small, export-based economy, the currency was one of the first to respond to the shift towards risk aversion. Reserve Bank of New Zealand Governor Alan Bollard has loosened rates substantially (with large rate cuts adding up to 325 basis points so far) and the potential for further easing is relatively high. However, with a benchmark still at 5.00%, the kiwi dollar could be in a good position should global rates stabilize soon. On the other hand, given the country’s shaky economy and thin liquidity, this currency may lag in the upswing in carry interest. 

Canadian Dollar – Through the last carry build up, the Canadian dollar did not enjoy the level attention that its Australian and New Zealand counterparts had received, but a relatively high yield did attract considerable carry flows. Since then, however, the benchmark lending rate has been lowered significantly and now falls near the lower half of the curve, at 1.50%. To remain a viable candidate, policy easing will have to let up to avoid rates near zero. Alternatively, compared to its neighbor, the United States, Canada’s economy and markets have proven to be relatively robust. This garners the Canadian currency considerable potential for a hawkish turn in global rates.

A Currency to Avoid

British Pound – The British pound cannot be easily placed into either the “funding” or “carry” currency category. Over the past year, the United Kingdom has dove into a considerable recession, and the outlook is even bleaker. What’s more, as the financial capital of the world, credit has been a particularly heavy weight for the pound to bear. In an effort to secure its markets and economy, the government has resorted to nationalizing major financial institutions, and the Bank of England has moved with sharp rate cuts that have lowered the benchmark to its current 2.00%. Forecasts are guided by discussion of a soon-to-be zero interest rate policy, and policy officials suggest that growth and deflation may still be problems, even if lending rates are brought that low. With such uncertainty, a low yield and a history of sudden shifts in the BOE’s policy stance, the British pound will prove a risky currency for investors looking for safety of funds first and foremost.

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By John Kicklighter, Currency Strategist, DailyFX.com

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