Carry trade comes back on increasing confidence

Bloomberg

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The carry trade is making a comeback after its longest losing streak in three decades.

Stimulus plans and near-zero interest rates in developed economies are boosting investor confidence in emerging markets and commodity-rich nations with interest rates as much as 12.9 percentage points higher. Using dollars, euros and yen to buy the currencies of Brazil, Hungary, Indonesia, South Africa, New Zealand and Australia earned 8 percent from March 20 to April 10, that trade’s biggest three-week gain since at least 1999, data compiled by Bloomberg show.

Goldman Sachs, Insight Investment Management and Fischer Francis Trees & Watts have begun recommending carry trades, which lost favor last year as the worst financial crisis since the Great Depression drove investors to the relative safety of Treasuries. Now efforts to end the first global recession since World War II are sending money into stocks, emerging markets and commodities.

"The global economy seems to have reached an inflection point," said Dale Thomas, head of currencies at Insight Investment Management in London, which oversees $121 billion. "We’re set for a period of some classic risk currency trades, where you sell the dollar against emerging-market currencies."

Carry trades use funds in countries with lower borrowing costs to invest in those with higher rates, allowing investors to pocket the difference. Speculators fled the strategy last year as central banks cut rates to revive growth, narrowing spreads, and as currency swings increased risks. Foreign-exchange volatility expectations surged 73 percent in three days to a record on Oct. 24, a JPMorgan Chase & Co. index shows.

Thomas recommends the Australian dollar and real in Brazil, where the benchmark central bank rate is 11.25 percent, or about 11 points more than the corresponding U.S. rate.

Profitable trading
Borrowing U.S. dollars at the three-month London interbank offered rate of 1.13 percent and using the proceeds to buy real and earn Brazil’s three-month deposit rate of 10.51 percent rate would net an annualized 9.38 percent, as long as both currencies remain stable.

Carry trades were profitable for most of the past three decades. They produced average annual returns of 21 percent in the 1980s with no down years, the best of four commonly used currency strategies, according to ABN Amro Holding indexes.

In the 1990s, carry-trade investors suffered three down years, including a 54 percent slide in 1992, ABN Amro data show. From 2000 to 2005, the trade was again on top with average gains of 16 percent.

Then it dropped three years in a row in 2006-08, the longest streak since 1976-78, for an annualized average loss of 16.5 percent through Feb. 28. Most of the decline came after June 2008 as the collapse of U.S. subprime mortgages froze credit markets and led to the bankruptcy of Lehman Brothers, the biggest corporate failure in history.

As investors fled to the safest assets, the greenback climbed 26 percent between July 15 and March 4, when it reached its highest in almost three years, according to the Intercontinental Exchange Dollar Index against the euro, yen, pound, Canadian dollar, Swiss franc and Swedish krona. Prices for Treasuries rose, sending the 10-year note yield to a record low of 2.0352 percent on Dec. 18, from 4.07 percent on Oct. 14.

Last month, the carry trade roared back, with ABN Amro’s index gaining 4.6 percent, its best month since September 2003. As of yesterday, the Dollar Index had fallen about 5.4 percent from its March 4 high.

An equally weighted basket of currencies consisting of Turkish Lira, Brazilian real, Hungarian forint, Indonesian rupiah, South African rand and Australian and New Zealand dollars - bought with yen, dollars and euros - earned an annualized 196 percent from March 2 to April 10. That trade produced a 41 percent annualized loss from September, when Lehman collapsed, through February.

Benchmark rates in those seven economies range from 3 percent in New Zealand and Australia to Brazil’s 11.25 percent. Comparable rates in the euro region, Japan and the U.S. are 1.25, 0.1 and between zero and 0.25 percent, respectively.

Falling volatility
Smaller swings in foreign exchange are making the carry trade less vulnerable to a sudden wipeout. Currency volatility expectations fell to a six-month low on Monday from the Oct. 24 record, the JPMorgan index shows.

"There are increasing signs that FX volatility has peaked," Goldman Sachs said in a report titled "Time to Reconsider Carry" on April 8. "The conditions are about to fall in place to make carry strategies attractive again."

The risk is that global economies will continue to shrink, leading investors back to the most-traded currencies - dollars, yen and euros - and forcing emerging economies to reduce benchmark rates to encourage growth, narrowing interest spreads.The U.S. recession, now in its 17th month, has cost 5.1 million Americans their jobs, the worst drop in the postwar era. Median estimates in a Bloomberg News economist survey predict unemployment will average 8.9 percent this year and more than 9 percent in 2010.