Forex
Analysis – Dollar slump, overcrowding complicate popular FX carry trade
© Reuters. FILE PHOTO: U.S. Dollar and Euro banknotes are seen in this illustration taken July 17, 2022. REUTERS/Dado Ruvic/Illustration
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.”
Investing.com – The US dollar has rallied strongly since the US Presidential election, from an already high level, and Bank of America Securities sees the currency now priced to perfection.
In real effective terms, BoA estimated that the dollar ended 2024 at a 55-year high, following the longest uptrend in recent decades, which started in mid-2011.
“The USD has also reached extreme levels in nominal terms. Using the BIS NEER broad index (nominal effective exchange rate), the USD is the strongest it has been in the last 30 years, which is when the time series started,” said analysts at BoA Securities, in a note dated Jan. 8.
The dollar appears overvalued by 18.5%, the most in the last 30 years except when it was overvalued by 19% during the energy shocks from the war in Ukraine in 2022, the bank said.
Its overvaluation increased by about 6.4% since the end of Q3 last year, to a large extent because of the US election. By comparison, it was overvalued only by 9.4% at the end of 2016, after Trump won his first US election.
Looking at G10 equilibrium estimates, the USD clearly stands out as the most overvalued – followed by CHF, with JPY and the Scandies being the most undervalued.
“We expect the USD to remain strong in the short term on the back of US inflationary policies, and particularly tariffs, but to weaken later in the year, as these policies take a toll on the US economy while the rest of the world responds. Policy uncertainty makes our baseline subject to substantial risks,” said BoA Securities.
Investing.com – The US dollar rose Wednesday, benefiting from rising bond yields after the release of healthy US economic data, while weak German industrial orders weighed on the euro.
At 04:35 ET (09:35 GMT), the Dollar Index, which tracks the greenback against a basket of six other currencies, traded 0.3% higher to 108.690.
Dollar gains as Treasury yields soar
The dollar has continued to push ahead Wednesday, following on from the prior session’s positive tone after data showed US unexpectedly rose in November, layoffs were low, while services sector activity accelerated in December and a measure of prices paid for inputs hit a two-year high.
This resulted in 10-year Treasury yields climbing to an eight-month high, while the benchmark 30-year yield came close to the 5% level.
“Yesterday’s US data releases were hawkish for the Fed, and the implied probability of a March rate cut has now dropped below 40%,” said analysts at ING, in a note.
“The most remarkable print was the ISM prices paid subcomponent, which spiked to the highest level since January 2023. If a generally resilient economy was already accounted for when the Fed met in December, a resurgence in inflation concerns could drive an even further hawkish tuning in the policy message.”
The Federal Reserve cut the number of rate cuts it sees this year to two at its December meeting, but traders are now only pricing in around 37 bps of easing through this year, according to LSEG data.
There is more data to digest Wednesday, in the form of the monthly and weekly , ahead of Friday’s release of the closely watched US for further clarity on the health of the world’s largest economy.
German economic weakness weighs on euro
In Europe, fell 0.2% to 1.0326, adding to the losses of around 0.5% overnight after the release of more disappointing economic data from the region’s largest economy – Germany.
fell 5.4% in November, sapped by a decline in large orders, while the country’s fell 0.6%, bursting hopes for a boost from pre-Christmas promotions like Black Friday and Cyber Monday.
Investors are currently looking for the to ease interest rates by around 100 basis points in the first half of 2025.
“There is only a speech by French central bank governor Villeroy to watch in the eurozone calendar today. EUR/USD may find decent support at 1.0300 for now,” said ING.
traded 0.2% lower to 1.2447, with little in the way of economic data due for release Wednesday, and only a speech from Bank of England Deputy Governor Sam Woods to digest.
The held interest rates unchanged last month, and is expected to proceed cautiously with further rate cuts this year with inflation still above target.
Yuan sentiment remains weak
In Asia, rose 0.1% to 7.3511, with the Chinese currency hitting its weakest level in 17 years earlier in the week.
Sentiment remains weak surrounding China ahead of President-elect Donald Trump’s inauguration on Jan. 20, with Trump having vowed to impose steep trade tariffs on China.
gained 0.1% to 158.19, after recovering marginally from its weakest level in nearly six months.
The yen stemmed its recent losses after government officials offered a verbal warning on potential currency market intervention, which saw traders adopt more caution in shorting the Japanese currency.
By Tom Westbrook and Greta Rosen Fondahn
SINGAPORE/GDANSK (Reuters) -The dollar rose for a second day on Wednesday on higher U.S. bond yields, sending other major currencies to multi-month lows, with a report that Donald Trump was mulling emergency measures to allow for a new tariff program also lending support.
The already-firm dollar climbed higher on Wednesday after CNN reported that President-elect Trump is considering declaring a national economic emergency as legal justification for a large swath of universal tariffs on allies and adversaries.
The was last up 0.5% at 109.24, not far from the two-year peak of 109.58 it hit last week.
Its gains were broad-based, with the euro down 0.43% at $1.0293 and Britain’s pound under particular pressure, down 1.09% at $1.2342.
Data on Tuesday showed U.S. job openings unexpectedly rose in November and layoffs were low, while a separate survey showed U.S. services sector activity accelerated in December and a measure of input prices hit a two-year high – a possible inflation warning.
Bond markets reacted by sending 10-year Treasury yields up more than eight basis points on Tuesday, with the yield climbing to 4.728% on Wednesday.
“We’re getting very strong U.S. numbers… which has rates going up,” said Bart Wakabayashi, Tokyo branch manager at State Street (NYSE:), pushing expectations of Fed rate cuts out to the northern summer or beyond.
“There’s even the discussion about, will they cut, or may they even hike? The narrative has changed quite significantly.”
Markets are now pricing in just 36 basis points of easing from the Fed this year, with a first cut in July.
U.S. private payrolls data due later in the session will be eyed for further clues on the likely path of U.S. rates.
Traders are jittery ahead of key U.S. labour data on Friday and the inauguration of Donald Trump on Jan. 20, with his second U.S. presidency expected to begin with a flurry of policy announcements and executive orders.
The move in the pound drew particular attention, as it came alongside a sharp sell-off in British stocks and government bonds. The 10-year gilt yield is at its highest since 2008. [GB/]
Higher yields in general are more likely to lead to a stronger currency, but not in this case.
“With a non-data driven rise in yields that is not driven by any positive news – and the trigger seems to be inflation concern in the U.S., and Treasuries are selling off – the correlation inverts,” said Francesco Pesole, currency analyst at ING.
“That doesn’t happen for every currency, but the pound remains more sensitive than most other currencies to a rise in yields, likely because there’s still this lack of confidence in the sustainability of budget measures.”
Markets did not welcome the budget from Britain’s new Labour government late last year.
Elsewhere, the yen sagged close to the 160 per dollar level that drew intervention last year, touching 158.55, its weakest on the dollar for nearly six months.
Japan’s consumer sentiment deteriorated in December, a government survey showed, casting doubt on the central bank’s view that solid household spending will underpin the economy and justify a rise in interest rates.
hit 7.3322 per dollar, the lowest level since September 2023.
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