Carry Trades Restore Profits as Volatility Plummets: Currencies

The drop in currency volatility to the lowest levels since 2007 is proving a boon to traders able to exploit differences in global interest rates.

A UBS AG index that tracks returns in carry trades in the foreign-exchange market has jumped 3.8 percent this year, trouncing what investors could get from stocks or bonds. A JPMorgan Chase & Co. measure of anticipated price swings in currencies plunged 20 percent in the same period to the least since the start of the global financial crisis.

Traders are now rushing to put on the trade, largely benefiting currencies of nations with relatively high rates. Investing in currencies has been a losing proposition the past three years as the world’s biggest central banks took control of markets by cutting borrowing costs and injecting trillions of dollars into the global financial system to aid growth. That’s damped trends traders rely on to make money.

“People have been sucked into carry trades,” Steve Barrow, the head of Group of 10 research at Standard Bank Plc in London, said in an April 7 phone interview. “If you’re a player in the FX market, how else are you going to make money? It’ll probably give emerging-market currencies some clear support.”

Trends Flattened

In carry trades, traders buy high-yielding assets using money borrowing in currencies of nations with lower borrowing costs. A drop in the funding currency or a rise in the target exchange rate adds to the return from the interest-rate differential. Lower volatility lessens the chance that the trade gets upended by sharp swings in exchange rates.

It has been a difficult few years in the $5.3 trillion-a-day currencies market, where the unprecedented amounts of money pumped around the world by central banks have flattened out many of the trends most followed by traders. Parker Global Strategies LLC’s Global Currency Managers Index, which tracks the performance of 14 funds it considers the elite in their class, is down 1.2 percent this year, extending its decline since the end of 2010 to 9.1 percent.

Investors have also had to deal with investigations on three continents into alleged rate manipulation that has seen dealers suspended from the U.S. to Singapore and Switzerland.

Fragile Five

The most profitable carry trade funded using U.S. dollars over the past month has been to purchase Brazil’s real, which handed investors an 8.2 percent profit, data compiled by Bloomberg show. Buying Turkey’s lira and Colombia’s peso gave the next-best greenback-funded gains, at 6.8 percent and 6.4 percent.

Morgan Stanley coined the term “fragile five” in August to describe emerging-market currencies that were particularly vulnerable to capital flight. The appeal of many of these currencies, from Turkey’s lira to South Africa’s rand and India’s rupee, has been boosted by interest-rate increases.

Turkey lifted its benchmark rate to 10 percent from 4.5 percent at a Jan. 28 emergency meeting, prompting a 7.3 percent rally. Brazil raised its target rate a quarter-point to 11 percent last week, while Indonesia has been raising its reference rate at the fastest pace since 2005.

“Low volatility helps the carry trade into the fragile five,” Adnan Akant, the New York-based chief investment officer for foreign-exchange at Fischer Francis Trees & Watts Inc., which oversees $50 billion, said in an April 8 phone interview. “These countries will probably keep receiving these flows as long as the global growth cycle continues and interest rates don’t spike higher in the developed world.”

‘Structural Issues’

Federal Reserve Chair Janet Yellen said March 19 that U.S. officials may raise interest rates “around six months” after they end the unprecedented bond purchases they’re using to push money around the globe. That’s a potential roadblock to the carry trade’s revival because higher rates in the developed world will make emerging markets’ returns less attractive.

“When the market sees the current-account deficit of countries like South Africa and Turkey widening again, they’ll question the carry trade outright,” Geoffrey Yu, a senior currency strategist at UBS in London, said in an interview yesterday on Bloomberg Radio. “We don’t think it’s sustainable. There are lots of structural issues within” emerging markets.

Global stocks and bonds performance have trailed currencies this year. The MSCI ACWI Index of shares rose 1.2 percent this year, while the Bank of America Merrill Lynch Global Broad Market Index returned 2.4 percent.

‘Goldilocks Scenario’

JPMorgan’s Global FX Volatility Index fell to 6.94 percent yesterday, the lowest level since July 2007 and down from a record 27 in October 2008, shortly after the collapse of Lehman Brothers Holdings Inc. The gauge was at 6.95 as of 12:17 p.m. in New York.

The biggest declines were in the emerging-market currencies that carry traders often favor because of their higher rates.

Three-month implied volatility for the greenback versus the Hungarian forint dropped to 10.33 percent yesterday, from 14.16 percent on Jan. 31, the most among 31 major currencies tracked by Bloomberg. The next-sharpest contraction in price swings was in the dollar versus the Polish zloty and Turkey’s lira, data compiled by Bloomberg show.

Traders across the industry are on guard after Bloomberg News reported in June that dealers had colluded to rig the WM/Reuters rate, a benchmark used by investors and companies.

At least two dozen traders have been fired, suspended or put on leave by banks including Citigroup Inc., Royal Bank of Scotland Group Plc and Barclays Plc. No firms or traders have been accused of wrongdoing by government authorities.

For now, at least, making money from carry trade is a welcome distraction from a year of upheaval.

“Volatility is back to pre-Lehman levels -- it’s made investors more comfortable taking risks,” Paresh Upadhyaya, the Boston-based director of currency strategy at Pioneer Investment Management Inc., which oversees $236 billion, said in an April 7 phone interview. “We’re almost at a Goldilocks scenario for emerging markets.”

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