The foreign currency markets are experiencing an atypical serenity that is prolonging the life of a profitable trade beyond the expectations of many.

It was anticipated that the so-called carry trade, which entails borrowing money in a low-interest currency to invest in a higher-yielding currency, would diminish as major central banks shift their focus from raising interest rates to easing policy.

But a significant change is still a ways off, which means that the trade, which depends on this stability, is still quite profitable.

“The carry trade is often known as picking up nickels in front of steam rollers, but speculators have been picking up bundles of $100 bills over the last year,” said Karl Schamotta, chief market strategist at payments company Corpay.

“The returns are outstripping virtually everything else.”

An research by Corpay Global Payments revealed that individuals who played the approach correctly received huge gains. Over the previous 12 months, buyers of the high-yielding Mexican peso who sold the Japanese yen would have profited by around 44 percent. Similar astronomical returns have also been produced by other well-known carry currencies.

In 2023, a Deutsche Bank index that tracks 21 developing market currencies’ carry performance increased by 6.6%, marking the index’s highest level since 2017. Over the past month, the so-called DB EM FC Equally Weighted Total Return index has increased by almost 1%.

But it seems like the tide is turning. The path for central banks to loosen policy in 2024 is paved by declining inflation in developing countries, which will reduce the gap in interest rates between the currencies with the highest and lowest yields.

Tuesday’s losses in US stocks came late in the day, when the Dow and S&P 500 saw their third consecutive decrease.

Mexico just lowered rates for the first time since it started tightening in the middle of 2021, joining Brazil, Chile, and Colombia in doing so.

“The carry trade is likely to run out of steam and while these currencies could see some further gains, those tailwinds that propelled them to large gains in 2023 look to have run their course,” said Jonathan Petersen, senior markets economist at Capital Economics.

Fed officials stated last week that they continue to anticipate lowering interest rates by 0.75 percentage points by the end of 2024. The Fed and the European Central Bank, however, are not likely to ease policy as quickly or to the same extent as emerging markets.

As a result, carry traders must use greater caution, according to Aaron Hurd, senior portfolio manager at State Street Global Advisors for currencies.

“It’s not quite an all clear environment that you had over the past year and a half,” he said. “We’re generally moving in the direction of being more cautious …, trying to take the higher quality or lower-risk carry trades now.”

Hurd is switching to the stable Swiss franc as a funding currency instead of the yen because he believes it is susceptible to a sudden move. He prefers to sell the Chinese yuan and purchase Indian rupees.

Interest rate volatility has been reduced in part by central banks acting in unison. The weighted average of anticipated volatility in nine main currency pairings, or the CVIX index of Deutsche Bank, recently fell to a level over two and a half years below.

It implies that investors are not prepared to give up on carry trades just yet.

“I think markets expected January or February to be more volatile months, where we would have seen a decline in U.S. data that would have warranted maybe Fed rate cuts already in March or in May,” said Francesco Pesole, forex strategist at ING in London. Instead, there were two months of strong U.S. data, he noted.

“We can definitely see another few weeks where carry remains relatively popular,” Pesole said.

Volatility has remained low despite significant changes in interest rates over the past few weeks, such as the unexpected cut by the Swiss National Bank and the long-awaited departure from negative interest rates by the Bank of Japan.

The three-month dollar/yen implied volatility, which gauges the expense of options contracts used by traders as hedging tools, is almost at its lowest point in the last three months.

Analysts noted that it wouldn’t take much to shake things up and upset the carry trade.

“It’s really hard to imagine things getting even calmer in FX markets,” Capital Economics’ Petersen said.

He pointed out that this year’s global elections, including those in the United States, geopolitical upheavals, economic data, and central bank policy decisions might all surprise people.

“The bottom line is that the bar is very low for volatility to creep higher from here.”

(Adapted from FastBull.com)

Categories: Economy & Finance, Regulations & Legal, Strategy