Photographer: Gianluca Colla/Bloomberg

Euro Wreaks Havoc on Carry Trades in Rally Almost No One Foresaw

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It was supposed to be so easy. Borrow in euros as the European Central Bank kept interest rates near zero and use the proceeds to invest in the economies where rates are higher, pocketing the difference and generating huge profits.

For a while it worked -- that was, until about a month ago when global markets began to go haywire and the euro, instead of weakening as most every strategist surveyed by Bloomberg predicted, began to rally. Investors who embraced the carry strategy have seen losses of 3.5 percent since the end of March, according to a UBS Group AG index.

“It’s not working,” said Neil Jones, head of hedge-fund sales at Mizuho Bank Ltd. in London. “This trade will become profitable again, but not quite yet. For now, it’s on ice.”

In many ways, the unexpected outcome mirrors the broader economy. Signs are emerging that the euro zone may not be in as bad a shape as forecast, and deflation isn’t likely. At the same time, the dollar has been falling amid worse- than-predicted U.S. data that dimmed odds of an imminent Federal Reserve rate increase.

What’s turned the strategy on its ear is the unexpected recovery in the euro. In a typical carry trade, speculators borrow in a currency they expect to depreciate or remain little changed to secure the lowest borrowing costs. The shared currency has strengthened 2.9 percent in the past month, according to Bloomberg Correlation-Weighted Indexes, forcing speculators to unwind unprofitable investments.

Exceeding Forecasts

At $1.1386, the euro is higher than all except one of the active mid-year forecasts in a Bloomberg survey of 98 contributors. The median estimate is for the shared currency to trade at $1.08.

Adding momentum to the euro’s reversal versus the dollar was a string of worse-than-predicted U.S. data that dimmed speculation the Fed is about to raise interest rates. At the same time, an ending of deflation expectations in Europe has pushed up German bond yields, making them more attractive on a relative basis and damping the appeal of Treasuries.

“Both sides of the equation are coming under question,” said Alan Ruskin, global head of Group of 10 foreign exchange at Deutsche Bank AG in New York. “What’s the appropriate funding currency is at least as important as where’s the attractive high yielder.”

Emerging Markets

Currencies that are often used to bet on gains in the carry trade such as the South African rand and Turkish lira have underperformed, Ruskin said.

Strategists at Morgan Stanley agree, and highlighted in a May 14 note that the failure of emerging-market currencies to rally in the past month has compounded negative carry affects from the euro’s resilience.

The International Monetary Fund estimated last month that developing countries will grow at the slowest pace relative to their advanced peers since 2000. It warned that rising U.S. interest rates and escalating geopolitical risks may add to pressure on the currencies.

Speculative investors cut by about half net bullish bets on the greenback since January, according to Commodity Futures Trading Commission data.

The reversals by both the euro and dollar have caused foreign-exchange hedge funds to suffer. Parker Global Strategies LLC’s gauge of 14 top currency funds dropped 0.7 percent in April, its worst month since the dollar started climbing in the middle of last year. It’s down 0.5 percent this month.

Disorderly Move

“The move in bunds had become disorderly and that increased the risk of volatility contagion, where you see high volatility and fairly broad-based deleveraging across markets,” said Paul Meggyesi, a foreign-exchange strategist at JPMorgan Chase & Co. in London. “Assets that are over-owned and over-positioned, and so over-valued, come under pressure. That’s exactly how I’d describe the dollar earlier this year, which is also increasingly devoid of near-term economic support.”

The two seemingly winning trades, betting on dollar appreciation and euro losses, gained steam last year even before European Central Bank President Mario Draghi unleashed a bond-buying program and as expectations oscillated on how far off a Fed rate increase was. Money-market trades signal the U.S. central bank will raise its near-zero policy rate in December.

“While the idea of a Fed rate hike isn’t front and center of market themes during this period, we do think the data will start to improve in the second quarter,” Nick Bennenbroek, head of currency strategy at Wells Fargo & Co., said from New York. “The euro appreciation, the unwinding of short euro carry trade can run a little further.”

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