A Big Carry Trade Is Putting Riksbank's Currency Agenda at Risk

  • Krona and Swiss franc are top G-10 currencies in carry trade
  • A more hawkish monetary environment adds volatility: Nordea

Of the 10 most-traded currencies in the world, only the Swiss franc ranks as high as Sweden’s krona when it comes to preferred vehicles for constructing a carry trade.

The bet -- borrowing in (and selling) low-yielding currencies and investing the proceeds in high-yielding markets -- makes sense as long as volatility is low and extra returns hard to come by. But with the U.S. Federal Reserve ending years of ultra-low rates, markets that have been shaped by carry trades could be in for a sizable adjustment.

Martin Enlund, chief analyst at Nordea Markets in Stockholm, says “the new narrative might become one of a global hawkish policy shift” that “would undermine risky assets, lead to increased volatility and, as a result,” trigger the “unwinding of carry trades.”

If that happens, Karl Steiner, chief quantitative strategist at SEB, says Sweden’s Riksbank will need to find new ways to keep the krona weak. But this time, the starting point is a negative benchmark interest rate and quantitative easing that’s already sucked up about 40 percent of the government bond market.

“If the krona strengthens too much, too rapidly that would spell problems for the Riksbank,” Steiner said by phone. “It would make it very hard for it to reach the inflation target in such a case.”

The chart shows what carry traders have been drawn to. Since early 2015, when the Riksbank embarked on its extreme stimulus measures, the euro-krona currency pair has traded higher, despite a decline in volatility. As the chart shows, that breaks with the trend over the previous half decade.

In the absence of any volatility spike, what could make the krona less attractive for funding cross-currency trades would be if the Riksbank raises rates or if yields rise globally, reducing the need for carry trades, RBC Markets Head of Global FX Strategy Adam Cole said in a note. “But the Riksbank shows no sign of moving closer to policy normalization.”

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