JPMorgan's Advice to Currency Traders: Keep Calm and Carry On, Briefly
The prospect of additional accommodation from the People's Bank of China, the European Central Bank, and the Bank of Japan, as well as fiscal stimulus in the world's second-largest economy has the potential to breathe life into one of the foreign exchange world's favorite trades.
But an analyst at JPMorgan Chase is warning currency traders not to get carried away with this more supportive backdrop for risk-taking.
"[T]he FX carry trade revival should be brief and narrow," wrote John Normand, JPMorgan's head of FX, commodities and international rates research.
The key reason: They're all carry trades with Chinese characteristics.
The term "carry trade" has morphed into a catch-all for any instance in which a trader takes a long position in a higher-yielding currency, such as the Brazilian real, and shorts a lower-yielding currency, typically the Japanese yen.
Now that Chinese policymakers are showing more willingness to prop up growth through monetary and fiscal channels, ECB President Mario Draghi has all but telegraphed more stimulus, and the Bank of Japan's inflation target remains elusive, such carry trades are back in vogue.
Normand isn't enthusiastic about the longevity of such trades, however, because they very nearly require him to be bullish on China's industrial cycle:
The causal nature of the relationship, according to Normand, stems from the link between Chinese demand for commodities and many emerging market economies' terms of trade: The credit-driven infrastructure boom in the world's second largest economy buoys commodity prices, in turn boosting the value of many currencies in the developing world.
This has led the strategist to assert that China's industrial production is the most important determinant of the fate of carry trades, aside from the evolution of Federal Reserve policy.
The notion of a carry trade has become divorced from its original meaning. In 2013, Mark Dow, founder of Dow Global Advisors, distinguished between a true carry trade and trades with positive carry in his must-read primer on the subject.
"If, when you establish the position, the majority of your ex-ante return comes from the interest rate differential [Dow's emphasis] between the asset you short (this can include cash) and the asset you go long, then you are putting on a carry trade," Dow wrote, meaning that you're using this position to fund a long position in short-term debt of the country whose currency you are long.
Put differently, when FX investors carry trade, any improvement in the value of the currency they are long relative to the one they're short is the cherry on top of the sundae, not the ice cream with sprinkles.
Relative to the Japanese yen and the euro—two of the most popular funding currencies in a post-Fed quantitative easing world—the implied volatilities for most emerging market currencies are well in excess of two-year yield spreads, the shorter part of the curve where FX/rates traders usually operate.
The universe of true carry trades, meanwhile, has dwindled, thanks in large part to spillovers from zero-interest-rate policy across developed economies and a prolonged stretch of subdued growth.
Some carry trades have enjoyed periods of success, even as the commodities supercycle has turned, but this has been all about bouts of currency weakness in the part of the pair that was shorted in anticipation of aggressive monetary easing:
Based on what truly constitutes a carry trade, per Dow's outline, that's tantamount to the tail wagging the dog. But as long as there's profit to be had, currency traders won't be fretting over whether it comes from the interest rate differential or exchange rate movements.
If, however, unconventional monetary policy is subject to the law of diminishing returns—both in its effects on the real economy and financial markets—there is reason to believe that so-called carry trade gains fueled by additional rounds of BoJ or ECB easing would be neither meaningful nor enduring.
"So it's hard to become enthusiastic about FX carry for more than a couple of months and a few percent unless one is also bullish on China for a few quarters and also dismissive of Fed hikes until at least spring 2016," concluded Normand.
So not only has the attractiveness of the Chinese carry trade been demolished, the factors that gave rise to its demise (the moderation in growth, capital outflows, and devaluation of the yuan) also portend the broader death of many other foreign exchange carry trades.