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BNY Mellon’s Simon Derrick briefly mentioned the carry trade last week.
This Thursday, the currency strategist is back with more detail
Think of the trade (where investors buy low-yielding currencies to fund purchases of higher-yielding currencies/assets) as a canary in the (crisis) coalmine, he suggests.
Here’s Derrick, with our highlights:
One of the more noticeable features of the "carry trade" is that the attraction of low yielding currencies as funding vehicles frequently leads to them proving initially unresponsive to impending crises. As we have noted previously, this was certainly the case during the first half of 2008. Despite a marked slowdown in the global economy in the face of historically high oil prices, a collapsing US housing market and the forced rescue of a US investment bank, investors continued to use the USD and JPY as a source of funding all the way through until mid-July. When the reversal came, however, it was dramatic as everyone looked to buy back their funding currencies at exactly the same time.
This was not the first time that this had happened over the past two decades. It could be argued that the first example of this willingness to ignore very real dangers came during the second half of the 1990's. Despite a rolling emerging market crisis that had originated in July 1997 in Thailand and had reached as far as South Africa by April of 1998, the JPY funded carry trade remained popular through until early August of 1998 when the combination of the Russian crisis and a notable change of stance by the Fed saw the trade begin to unwind. Following the collapse of Long Term Capital Management at the end of September and a subsequent broad retreat from risk in the days afterwards, October 7th became one of the most notable days in foreign exchange history as USD/JPY collapsed 12 big figures in a matter of hours.
Probably the most iconic of currency pairs when considering the "carry trade" over the past decade and a half has been AUD/JPY. Since June of 1995 the pair has staged two major rallies (June 1995/May 1997 and September 2001/July 2007), each followed by around 12 months of ultimately inconsequential trading and a subsequent collapse that ended up taking the pair right back to where the uptrend had started. Tellingly, although the turn from the absolute peaks in May 1997 and July 2007 were (of course) marked by spikes in measured volatility, the subsequent 12 months or so of inconsequential trading (prior to the major collapse) were, in each case, characterised by a clear decline in historical volatility. In both cases in the weeks immediately before the collapse, 21 day historical volatility (measured on a OHLC basis) had declined to around 12% before subsequently spiking very sharply higher.
Why does this matter today? The most obvious reason remains the growing risks to broad sentiment in global markets (whether from the unpredictable path of events in the MENA region or the risk of a third stage to the Eurozone crisis). Added to this, of course, remains the rather more cautious tone adopted of late by senior members of the RBA (notably, Governor Glenn Stevens on February 11th: "It is probably reasonable that there will be no hike in interest rates for some time') along with concerns expressed about the strength of the AUD by, amongst others, Prime Minister Julia Gillard. There is, however, a third reason, namely the price action itself. In particular it is noticeable that since the price peaked out in May of last year it has become locked in an increasingly moribund pattern (as has our flow data for the AUD). In line with this, after an initial spike in 21 day historical volatility last May, the past ten months has seen a steady decline leaving it currently standing at around 11.23% (making it just about the quietest period since the summer of 2007). Given our observations about market conditions in the summers of 1998 and 2008 this seems worthy of note.
One more thing to watch:
Related links: Black Swan fatigue - FT Alphaville The pictorial, speculative, yen carry trade - FT Alphaville Bonfire of the carry trades – FT Alphaville, 2008
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