Carry-Trade Losses Rise to Most in Two Years Amid Europe Sovereign Crisis

Foreign-exchange losses from carry trades climbed to the highest level in more than two years as hedge funds and other large speculators unwound bets that the euro will strengthen amid Europe’s sovereign-debt crisis.

Royal Bank of Scotland Plc’s index for carry trades, whereby investors tap cash where borrowing costs are low to invest in higher rates elsewhere, fell 9.7 percent in November, the biggest drop since October 2008. The euro sank 6.9 percent in November against the dollar, the steepest monthly drop since May, as Ireland joined Greece in taking a bailout and North Korea shelled an island of its southern neighbor.

“The euro-zone’s sovereign risks and Korea tensions likely spurred players to reduce positions in carry trades,” said Morio Okayasu, chief analyst in Tokyo at FOREX.com Japan Co., a unit of online currency trading firm Gain Capital in Bedminster, New Jersey. “There’s a possibility that the euro could fall to around the $1.2600 level by year-end.”

The euro rose to $1.3032 as of 7:01 a.m. in London from $1.2983 in New York yesterday, when it touched $1.2969, the lowest level since Sept. 15. The single currency bought 108.61 yen from 108.65 yen yesterday, when it reached 108.35 yen, also the weakest since Sept. 15.

BNP Paribas SA strategists said in a Nov. 29 research report that carry trades using the dollar as a funding currency are “now at risk of putting the dollar into demand” as “geopolitical and economic fears” in Asia start to spill over into international asset markets.

Europe’s Debt Crisis

The European Union’s 85 billion-euro ($111 billion) rescue package for Ireland failed to quell market turmoil as investors shifted focus to the finances of Portugal and Spain.

Credit-default swaps protecting from losses on Portugal’s debt rose 4.5 basis points to 542.9 yesterday, according to data provider CMA. Contracts on Spain increased 13 basis points to 364 and those on Italy jumped 22 basis points to 268.

Traders reversed bets on the euro’s gains versus the greenback, Commodity Futures Trading Commission data showed this week. The difference in the number of wagers by hedge funds and other large speculators on a decline in the euro compared with those on a gain -- so-called net shorts -- was 8,293 on Nov. 23, compared with net longs of 8,606 a week earlier.

‘Brink of War’

U.S. and South Korean armed forces began four days of military exercises off the Korean Peninsula’s western coast on Nov. 28, a move the North said was bringing the region to “the brink of war.” The U.S. military has said the exercises are “defensive in nature” and were planned before North Korea’s Nov. 23 shelling of Yeonpyeong island near the disputed western border killed four people.

Carry trades, which flourish most when interest-rate spreads are wide and swings in exchange rates muted, have lost 4.4 percent so far in 2010, RBS index data show.

Higher volatility undermines the appeal of carry trades by increasing the probability that swings in exchange rates will erode gains. The JPMorgan Chase & Co. G7 Volatility Index rose by as much as 2.1 percent to 13.14 yesterday, the highest level since July 5 on a closing basis, hurting carry trade returns.

To contact the reporter on this story: Ron Harui in Tokyo at rharui@bloomberg.net.

To contact the editor responsible for this story: Rocky Swift at rswift5@bloomberg.net.

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