Carry Trades Lose Most Since ’11 as HSBC Gauge Warns: Currencies

Carry Trades Lose Most Since ’11 as HSBC Gauge Warns
The Bank of Japan added 11 trillion yen ($137 billion) to increase its fund to 66 trillion yen on Oct. 30. Photographer: Kiyoshi Ota/Bloomberg

The foreign-exchange market is signaling more pain ahead for currencies that benefit from a sustained global recovery, five years after the onset of the worst financial crisis since the Great Depression.

HSBC Holdings Plc’s Global Hazard Indicator, which combines implied volatility readings in options for the dollar, euro and yen, shows wider price swings in currencies over the next year than in the coming three months. If history is any guide, that means the dollar and yen will strengthen and higher-yielding, higher-risk currencies such as the Brazilian real and South African rand will depreciate.

While reports in the U.S. show gains in jobs and consumer confidence, and data from China signal that services industries are rebounding from 19-month lows, foreign-exchange speculation is a losing bet. The UBS V24 Carry Index that tracks profits from the so-called carry trade, where money borrowed in low-yielding currencies is used to buy those from nations with higher rates, is at about the lowest level since early 2011.

“The market is not yet fully convinced that we are back to normal trading conditions, and sees the potential for renewed turbulence in 2013,” said Daragh Maher, a strategist at HSBC in London. “There are plenty of potential triggers for renewed volatility on the horizon,” he said, citing potential spending cuts and tax increases in the U.S., the sovereign-debt crisis in Europe and political change in China.

Easy Profits

Investing the proceeds of dollar-denominated loans should offer easy profits because the Fed has said it probably will keep the target rate for overnight lending between banks near zero through mid-2015. The carry trade can lose money when the currency used to fund the strategy strengthens, or the targeted currency weakens, or some combination.

Instead, selling borrowed dollars to buy reais in Brazil, where the target interest rate is 7.25 percent, has lost about 5 percent this year as the real tumbled 23 percent from its 2012 high in February as of 1:44 p.m. in New York, according to data compiled by Bloomberg. The same trade with the rand has lost about 4.8 percent.

“The ample provision of liquidity by central banks is at least helping to calm markets and make them more stable than they would otherwise be,” Nick Bennenbroek, head of currency strategy at Wells Fargo & Co. in New York, said in a Nov. 7 telephone interview. “The tendency for major currencies to be driven by interest rates is somewhat diminished compared to where it has been in the past.”

Declining Speculation

Foreign-exchange speculation is declining as $607 billion in U.S. spending cuts and tax increases set to take effect Jan. 1, concern that European leaders aren’t moving fast enough to fix the region’s debt crisis, and slowing growth in emerging economies from China to Brazil weigh on sentiment.

The world economy will expand 3.3 percent this year, the least since the 2009 recession, the International Monetary Fund said on Oct. 9. The Washington-based IMF also said it sees an “alarmingly high” risk of a steeper slowdown.

Average daily volume in foreign exchange conducted through ICAP Plc’s EBS trading system fell 46 percent in October from a year earlier, the company said last week.

For all the efforts to restore confidence in the financial system, the world’s foreign-exchange market, where $4 trillion trades each day, is saying that the global economy can’t stand on its own without the unprecedented stimulus by the Federal Reserve, European Central Bank and Bank of Japan.

Dollar Favored

The euro slid as much as 0.4 percent to $1.2662 today, the weakest since Sept. 7. The yen gained against most of its major counterparts, climbing 0.2 percent to 100.87 per euro and 0.1 percent to 79.40 versus the dollar.

Rising volatility may favor the dollar as investors seek the haven of the world’s reserve currency. The euro will depreciate to $1.25 next year, and the dollar will strengthen to 83 yen from 79.40, according to median estimates of more than 35 strategists surveyed by Bloomberg.

HSBC’s three-month hazard index was most recently at 10.3 percent, below the one-year level of 12.1 percent. The three-month gauge topped the one-year measure by the widest margin in October 2008, a month after Lehman Brothers Holdings Inc. filed for bankruptcy and pushed the financial system into crisis.

The amount by which the one-year index exceeded the three-month measure peaked at 2.9 percent in March 2011, just before the global economy faltered and the MSCI All-Country World Index slid 18.3 percent over the next six months.

The discrepancy may be more a reflection of investors paring bets, rather than speculation for a weakening economy, according to Steven Englander of Citigroup Inc.

‘Very Soft’

Investors who wagered on increased realized volatility may be getting discouraged by a lack of price fluctuation, causing them to unwind positions and artificially drive down near-term contracts, he said.

“With realized volatility so low, everybody who bought volatility sees their positions losing value, which means they sell it back into the market,” Englander, head of Group of 10 currency strategy at Citigroup in New York, said in a Nov. 7 telephone interview. “Until that process is finished, you have short-term volatilities looking very soft.”

Realized volatility on one-month euro-dollar options reached its lowest level since 2007 on Oct. 31, dropping to 6.76 percent. Historical volatility for three-month euro-dollar contracts fell to 7.42 on Nov. 6, also the weakest since 2007.

The euro will decline to $1.22 by the end of 2013, according to Citigroup. Wells Fargo, the most-accurate currency forecaster as of Sept. 20, also sees the euro slipping to $1.22 against the dollar over that period.


HSBC expects the opposite, with the greenback’s status as a haven diminishing on the approaching fiscal cliff as investors reduce dollar holdings linked to the U.S.’s mounting economic burden, Maher said. The euro will rise to $1.40 by the end of 2013, HSBC projects.

Even with the extra stimulus by central banks, the IMF said it sees a one-in-six chance of growth slipping below 2 percent.

The Bank of Japan added 11 trillion yen ($137 billion) to increase its asset-purchase fund, it’s main policy tool, to 66 trillion yen on Oct. 30. The central bank also said it would offer unlimited loans to banks.

Fed Chairman Ben S. Bernanke said Sept. 13 that the central bank would purchase $40 billion of mortgage bonds a month until an economic recovery is well-established, on top of two earlier rounds of bond purchases totaling $2.3 trillion from December 2008 and June 2011.

ECB President Mario Draghi said on Sept. 6 that policy makers agreed to an unlimited bond-purchase program to regain control of interest rates in the euro area and fight speculation of a currency breakup.

‘High Volatility’

“If you believe that an activist central bank will keep fighting, that suggests growth, which also means high liquidity and low volatility,” Shahab Jalinoos, a Stamford, Connecticut-based senior currency strategist at UBS AG, said in a Nov. 8 telephone interview. “If you think that you don’t have an activist central bank, or have one whose hands are tied by something, then you probably will see high volatility.”

Confidence among U.S. consumers climbed to a five-year high in November, while payrolls expanded by 171,000 workers in October, exceeding the highest forecast in a Bloomberg survey. China’s services industries rebounded in October from the slowest expansion in at least 19 months, adding to manufacturing gains.

Meanwhile, growth in Brazil, the largest emerging economy after China, will average 1.5 percent this year, less than the U.S. or Japan, according to 30 economists’ estimates compiled by Bloomberg.

The European Commission said the euro-area economy will stagnate next year as the sovereign-debt crisis engulfing southern Europe begins to slow export-driven Germany.

“This is going to be a very slow recovery process,” Wells Fargo’s Bennenbroek said. “Neither the official institutions, nor the private investors, are looking for a strong rebound from the major economies in any near- to medium-term time frame.”

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