Forex

Analysis – Dollar slump, overcrowding complicate popular FX carry trade

Published

1 year ago

July 26, 2023

Analysis - Dollar slump, overcrowding complicate popular FX carry trade

By Harry Robertson, Alun John and Ankur Banerjee

LONDON/SINGAPORE (Reuters) – A slide in the dollar and signs that volatility is returning to foreign exchange markets as interest-rate hikes bite is causing investors to reassess wildly popular carry trades and to be pickier about which currencies they back.

The carry trade – an investment strategy that takes advantage of differences in borrowing costs between countries – has provided bumper returns this year as most central banks have hiked rates, causing yields to rise, but at different paces.

“The world’s favourite carry trade,” according to Bank of America, involves investors borrowing Japanese yen where the central bank has pinned rates low, and converting them to to buy much higher-yielding bonds.

bond yields are about 0.1% in negative territory in Japan, but their yield around 11%.

A hypothetical $50,000 invested in a short , long peso carry trade for the first six months of the year would have yielded a profit of $15,100, according to Refinitiv Eikon.

“Carry has been very much in focus in the first half of the year,” said Kamakshya Trivedi, head of global FX, rates and EM strategy at Goldman Sachs. “Something like 70% of the cross section of moves (in EM currencies) can be explained by carry.”

Deutsche Bank’s emerging market carry strategy index had its best year on record in the 12 months to May.

But the trade could be jolted this week as the Federal Reserve, European Central Bank and Bank of Japan all set interest rates and give clues on the monetary policy outlook.

OVERCROWDING FEARS

Investors, however, are becoming concerned the carry trade might be becoming too popular for its own good.

“You have to be worried about some of these more crowded positions,” said Stephen Gallo, European head of FX strategy at BMO Capital Markets.

Gallo said a pick-up in market volatility or a fall in EM interest rates could trigger a rush for the exits.

James Athey, investment director at abrdn, said: “Things like the Mexican peso have been heavily positioned for quite some time, it’s sort of felt like you’re increasingly picking up pennies in front of a steamroller.”

Volatility matters, as an appreciation in the currency in which investors borrow, or a depreciation in the one in which they invest, can wipe out gains from yield differentials.

The yen has already hinted at snapping back, firming from 145 per dollar to 137 in the first half of July.

“I think that is big enough to offset any carry trade income,” said Yujiro Goto, head of FX strategy for Japan at Nomura.

Volatility has been low so far this year because most central banks have been raising interest rates broadly in tandem and nothing major has broken in the global economy, said Oliver Brennan, FX volatility strategist at BNP Paribas.

Now, things look different: the Fed looks set to pause, the Bank of England still has ground to cover, some emerging market central banks are considering cuts, and the Bank of Japan is keeping traders guessing.

The volatility of the world’s five most-traded currencies fell to its lowest in a year and a half in June, according to CME Group’s options-based volatility gauge, but has since ticked higher.

“From here, the risk is there is less (policy) convergence and more uncertainty,” Brennan said.

THE DOLLAR SLIDES

Emerging markets haven’t been the only focus. Investors have also flocked to higher U.S. bond yields compared to many countries by going “long” on the dollar.

Yet the has slid 2% against a basket of major currencies this month so far, after a sharp slowdown in U.S. inflation in June raised hopes that the Federal Reserve is approaching its final interest rate hike.

This “benign disinflation” in the U.S. may help dollar-funded emerging market carry trades continue to do well, said Robin Winkler, FX strategist at Deutsche Bank.

“In G10, however, the negative USD turn is not necessarily positive for carry, seeing as the USD has been a favored long,” he said.

“Japan’s yen in particular, but also the Swiss franc and Swedish or Norwegian crowns, have been used as funding currencies for USD longs for a long time,” he said. “As a result, these USD pairs have come under heavy pressure.”

A hypothetical $50,000 invested in a short Norwegian crown, long dollar carry trade in the first three weeks of July would have lost $3,000, according to Refinitiv.

Goldman’s Trivedi said carry trades can still reap rewards, particularly if emerging markets are boosted by Chinese stimulus. He recommended not simply picking the highest-yielding currencies, however.

“Adding currencies that have quite a lot of cyclical exposure makes sense, because in a world in which growth is going to be stronger… that includes things like the in Latin America or the in Asia.”

Geoff Yu, market strategist at BNY Mellon, said the outlook was relatively benign but remained uncertain.

“Just be selective right now,” he said. “You just don’t want to basically double up, or triple up, on risk exposure.”

Forex

Asia FX rises as rate cut dents dollar; yen firms as BOJ holds course

Published

16 hours ago

September 20, 2024

Investing.com– Most Asian currencies firmed on Friday, while the dollar nursed losses after the Federal Reserve cut rates by a wide margin and kicked off an easing cycle.

The Japanese yen was among the better performers, strengthening after the Bank of Japan held interest rates and said it expected steady increases in inflation and economic growth.

The Chinese yuan also firmed after the People’s Bank of China kept its benchmark rates unchanged, ducking some expectations that it would cut rates to further support the economy.

Yen firm as BOJ holds rates, flags higher inflation

The Japanese yen firmed on Friday, with the pair falling 0.2% to 142.28 yen.

The BOJ in a unanimous decision, and said it expected inflation and economic growth to steadily increase.

While the central bank did not provide any overtly hawkish cues, its forecast of higher inflation tied into expectations that the BOJ will raise interest rates further. A slew of policymakers had signaled that rates will rise further in the coming months, especially as inflation picks up.

The BOJ decision and forecast came just hours after data showed inflation rose to a 10-month high in August, as increased wages pushed up private consumption.

While the yen was nursing weekly losses, it still remained close to its strongest levels for 2024, hit earlier in the week. Expectations of higher interest rates are likely to underpin the yen in the coming months.

Dollar weak after rate cut cheer offsets less dovish Fed signals

The and both fell slightly in Asian trade, extending overnight declines as markets looked to lower U.S. interest rates.

The Fed and announced the start of an easing cycle, which could see rates fall by as much as 125 bps by the year-end.

But Fed Chair Powell offered a less dovish outlook for medium-to-long term rates, stating that the central bank’s neutral rate will be much higher than seen in the past. His comments limited overall losses in the dollar, and had also seen the greenback appreciate in the immediate aftermath of the Fed decision on Wednesday.

Chinese yuan at 16-mth high as PBOC holds rates

The Chinese yuan firmed on Friday, with the pair falling 0.3% to its lowest level since May 2023.

Strength in the yuan came as the PBOC kept its benchmark steady, ducking some expectations that it would cut rates further to stimulate the economy.

The PBOC’s decision came even as a raft of recent economic indicators showed sustained weakness in China.

But media reports said the PBOC was instructing local banks to buy dollars and limit overall strength in the yuan, given that a stronger yuan also weighs on Chinese exports.

Broader Asian currencies firmed after the Fed’s decision. The Australian dollar’s pair rose 0.2% and was close to an eight-month high.

The South Korean won’s pair was an outlier, rising 0.2%, while the Singapore dollar’s pair fell 0.1%.

The Indian rupee’s pair fell 0.1%, pulling back further from record highs hit earlier this year.

Forex

Stay long on the yen amid rate hikes, improving growth- BCA

Published

16 hours ago

September 20, 2024

Investing.com– BCA Research said bets on a stronger Japanese yen were becoming more entrenched amid attractive valuations in local assets, the prospect of more interest rate hikes and an improving Japanese economy.

The yen saw a stellar recovery over the past two months, as a hawkish Bank of Japan, a weaker dollar and an unwinding carry trade pushed the currency to 2024 peaks. The pair had fallen as low as 139 yen in recent weeks.

BCA Research said in a recent note that the yen was a “high-conviction” buy, and that interest rates and global economic conditions were likely to favor the currency in the coming months.

BCA expects the BOJ to this week. But a “dovish hold” is an opportunity to accumulate more yen, while an unexpected rate hike is set to further boost the currency.

The research firm said the Japanese economy remained resilient, with increases in local wages helping spruce up private consumption.

With the Federal Reserve beginning an easing cycle, and with the BOJ likely to hike interest rates further, BCA sees interest rate differentials still moving in favor of the yen in the long term- more so if the global economy enters a recession.

BCA expects Japanese inflation to rise further in the coming months, tieing into the BOJ’s forecasts and giving the central bank more headroom to raise interest rates. The central bank hiked rates twice so far this year, ending years of easy monetary policy on expectations of an uptick in private consumption and inflation.

While the BOJ is expected to keep rates on hold in the near-term, especially with a looming leadership change in the Japanese government, it is still expected to keep raising rates by end-2024 and going into 2025. BCA said an interest rate hike will “not hurt Japan.”

On Japanese equities, however, BCA was less enthusiastic, rating them as “structurally neutral.” The firm cited yen strength as a headwind, and saw no immediate positive developments in ongoing corporate governance and structural reforms.

Forex

Dollar slips in choppy trading as traders grapple with Fed’s giant rate cut

Published

16 hours ago

September 20, 2024

(Adds missing “cuts” in first bullet, no other changes to text)

By Chibuike Oguh and Stefano Rebaudo

NEW YORK (Reuters) – The U.S. dollar slipped in choppy trading on Wednesday as markets grappled with the supersized 50 basis point interest rate cut, as well as the switch to an easing monetary policy stance delivered by the Federal Reserve.

Investor expectations had largely shifted towards a dovish outcome in the days leading up to the Fed’s move on Wednesday, with money markets pricing in around a 65% chance of a 50 basis point (bp) cut. But economists polled by Reuters were leaning towards a 25 bp cut.

“The interesting thing is the half point cut, which was pretty much unexpected or at least only half and half yesterday, has not really given the dollar extra damage – which is quite surprising,” said Joseph Trevisani, senior analyst at FXStreet in New York.

The , which measures the greenback against a basket of six peers, was down 0.38% to 100.64 after reversing gains made in early trading. It slid to its lowest in more than a year of 100.21 in the previous session.

The euro strengthened 0.4% to $1.1163. Against the yen, the dollar was 0.33% higher at 142.73 as markets anticipate that the Bank of Japan will leave interest rates unchanged on Friday.

The dollar weakened 0.08% to 0.847 against the Swiss franc and dropped 0.34% to 7.070 versus the offshore .

“What it’s really doing I think is giving permission, if you will, for the other central banks around the world, some of whom have started to cut rates already, to go further with their rate cuts,” Trevisani said.

Money markets priced in 72 bps of additional rate cuts in 2024 and 192 bps by September 2025.

The U.S. Treasury yield curve, which measures the gap between yields on two- and and seen as an indicator of economic expectations, steepened and hit its highest since June 2022. It was last at a positive 13.4 basis points, indicating more upcoming rate cuts.

Initial claims for state unemployment benefits dropped unexpectedly to 12,000 last week, according to Labor Department data on Thursday, suggesting labor market growth.

Fed policymakers on Wednesday projected the benchmark interest rate would fall by another half of a percentage point by the end of this year, a full percentage point next year and half of a percentage point in 2026.

“The initial interpretation of the decision was that it was dovish and while it was basically even odds that it was going to happen, overall, on the surface, it’s still a dovish move,” said Eugene Epstein, head of trading & structured products North America at Moneycorp in Boston.

“Everything reversed basically by the end of the day, so you can make the argument as a bit of buy the rumour, sell the fact. A lot of dovishness was already priced in.”

The pound hit its highest since March 2022 versus the dollar after the Bank of England’s Monetary Policy Committee (MPC) voted 8-1 to keep rates on hold. Sterling was up 0.5% against the greenback at $1.3278 after reaching as high as $1.3314.

The Australian and New Zealand dollars drew support from domestic data surprises. Australian employment exceeded forecasts for a third straight month in August.

The was up 0.77% to $0.6815.

The , meanwhile, traded 0.58% higher at $0.6244, after data showed the New Zealand economy contracted by 0.2% in the second quarter.

Currency bid prices at 19

September 07:17 p.m. GMT

Description RIC Last U.S. Close Previous Session Pct Change YTD Pct High Bid Low Bid

Dollar index 100.62 101.02 -0.39% -0.74% 101.47 100.51

Euro/Dollar 1.1162 1.1118 0.4% 1.13% $1.1179 $1.1069

Dollar/Yen 142.61 142.3 0.22% 1.11% 143.875 141.885

Euro/Yen 1.1162 158.18 0.64% 2.29% 159.96 157.79

Dollar/Swiss 0.8469 0.8463 0.06% 0.62% 0.8515 0.845

Sterling/Dollar 1.3276 1.3214 0.51% 4.37% $1.3314 $1.3155

Dollar/Canadian 1.3559 1.3606 -0.34% 2.29% 1.3648 1.3534