Macro Wrap-Up

Does Anyone Remember the Carry Trade?

Topics - Macroeconomics

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Does Anyone Remember the Carry Trade?

Developed currency carry trades appeal to people who like the idea of living just a little dangerously. They’re not for cliff divers, but for folks whose idea of adventure is refusing to put their smartphones in airplane mode during taxi and takeoff. 1 1 Close One of my colleagues disagrees. He thinks it is like picking up pennies in front of a steamroller, and the steamroller arrives just when your family has come to help you with the picking. In a carry portfolio, an investor buys currencies which offer high yields (carry currencies) while selling the ones with low yields (funding currencies). 2 2 Close There are many ways to construct an FX carry portfolio. You can choose to take into account historical yield averages. You can adjust for economic variables. You can use real or nominal yields. You can also just buy the ones that yield the most and not really think about it. For illustrative purposes only and not representative of a portfolio that AQR currently manages. There is no guarantee that this strategy will be profitable. Not to be construed as investment advice or a recommendation to buy, hold or sell a security. A carry trade refers to a single currency pair with the same characteristics. While carry portfolios are frequently discussed in the context of factor investing, carry trades have been conspicuously absent from market commentary. 3 3 Close We, for example, talk about them a lot. Others, not so much. Carry hasn’t been the source of special criticism, but like other macro strategies, it has been affected by low interest rates and lack of dispersion, issues that have perhaps reduced its cachet.

Academics have examined the potential outperformance of higher-yielding currencies since at least the early 1980s. 4 4 Close See Bilson (1981) and Fama (1984). The argument they generally make is that carry is a risk premium. Higher carry currencies have more exposure to risks such as economic volatility or trade unwinds, and investors are rewarded for taking those risks. 5 5 Close Academics have come up with several theories as to which risks carry investors are taking. From investors’ perspective, it may not matter which one is right. For many years, long the Australian dollar and short the Japanese yen was one of the more popular currency pairs, and it served as a textbook illustration of what you might expect in a risk premium. Japan had near zero interest rates and low growth. When the global economy slowed or there were economic shocks in Japan, the yen would often rally as Japanese investors repatriated money from foreign holdings. Australia had higher rates and higher growth, but its economy was more sensitive to the global business cycle, and may have been vulnerable to foreign capital flight. Buyers of the Australian dollar received significantly more interest, but during liquidity droughts, such as in 1998 and 2008, it fell sharply while the Japanese yen performed well. 6 6 Close The Australian dollar lost -18% against the Japanese yen in 1998 and lost -35% in 2008. Source: Bloomberg.

The strategy’s popularity was natural. It was easily understood and just risky enough to draw interest, but it didn’t appear too risky to scare investors away. As with any strategy, it was also the source of ongoing research. Some investors were aware of the carry risk premium theories and thought they could improve the returns by being tactical. Through some clever tricks, maybe they could collect the carry during the good times and then get out before the risks were realized. Carry-timing became quite trendy around 2010 or so, but it proved to be more difficult than many had anticipated and is no longer considered a cutting edge area of research. It probably takes the same place in people’s memories as a poorly received Valentine’s Day dinner from a decade ago, something promising that you spent a lot time thinking about, but not something you want to revisit any time soon. 7 7 Close We all have our good years and bad years.

The strategy has since gained traction in factor portfolios, but attitudes toward individual carry trades changed as a series of economic crises rearranged the relationships among currencies. After many countries cut rates in reaction to economic weakness, interest rate differentials got a lot narrower. The relationships among the currencies became much less intuitive. The sovereign crisis helped push rates below zero in much of Europe, and the yen was no longer the lowest-yielding funding currency. The premium for holding Australian and New Zealand dollars fell – rates are below 2% in those countries. 8 8 Close Australia’s policy rate is 1.50% and New Zealand’s policy rate is 1.75%. Sources: Reserve Bank of Australia, Reserve Bank of New Zealand. Surprisingly, the U.S. dollar is now the highest-yielding currency in the G10. 9 9 Close The Federal Reserve’s target range for its policy rate is 2.25% - 2.50%. Source: Federal Reserve. 10 10 Close The U.S. dollar has always puzzled carry investors because it has switched from a high to low yielder and then back again. All of this makes discussions of carry trades more difficult. There is no longer an obvious Japanese yen vs. Australian dollar trade to point to.

There is also the perception that narrower yield spreads mean that the risk premium in carry trades has fallen. However, currency volatility is also low, which may offset some of that effect. 11 11 Close Low volatility can help the carry trade, because it makes it less likely the high yielders will depreciate enough to offset the carry. In other words, there may be less risk in markets. However, Pedersen et al. (2008) find better returns for higher yielding currencies when the VIX is higher and TED spreads are wider, which they say may be related to lower funding liquidity. A full discussion of this topic is beyond the scope of a footnote in a weekly wrap-up. During the crisis years, the correlation between the carry portfolios and risk markets rose sharply and has only fallen slowly in the years since. It makes sense that big macro events like a crisis would overwhelm individual currency movements and raise this correlation, but it is odd that it would remain elevated in a period of relative macro-economic stability. Sometimes markets have memories. 12 12 Close Other times it feels like they can’t remember what happened yesterday.

The elevated correlation makes carry less intriguing as it gets subsumed by the general risk on/risk off narrative. Other strategies, such as option selling, have gained more media attention. Pundits may mistakenly think that the FX carry trades are only for the true thrill seeker, one who likes the risk, but doesn’t really care much about reward.

At some point, out of favor strategies gain adherents just for being out of favor. Investors who are worried about all of their crowded trades are naturally drawn to the forgotten ones even if justification for such behavior is hard to find. At some point, people will start talking about carry trades again. Perhaps the relationships among currencies will become more intuitive and carry will once again be an easy explanation for market behavior. Or, there could be a slow market news week which leaves writers with nothing else to fill their pages.

What We Are Watching

Federal Open Market Committee Minutes (Wednesday) The three-week delayed release of the FOMC minutes after each monetary policy meeting can dilute the impact they have. This week's minutes, however, could be more impactful than usual given the meaningful shift in tone from the Fed since the beginning of the year and at its January 30th meeting. In its monetary policy statement released following the meeting, the Fed stated it “will be patient as it determines what future adjustments to the target range for the federal funds rate may be appropriate.” During his press conference, Chair Powell mentioned some of the uncertainties and risks facing the U.S. economy that led the Fed to shift to a more neutral stance, however, questions were left around how long the Fed’s pause may be and what it would take to move it one direction or the other after the pause. The FOMC minutes will be scrutinized to see if any key conversations were had around forward-looking policy. Conversations around the terminal size of the Fed’s balance sheet will also be a focus, as a shift in stance to potentially ending tapering sooner than previously expected has had some market impact.

Australian Labor Market Data (Wednesday) Risks surrounding the Australian economy have increased, highlighted by weaker than expected housing and trade data. The Reserve Bank of Australia has also recently shifted its forecasts lower and has altered its marginally positive outlook to one that is more balanced and focused on several of the downside risks to the economy. One of the downside risks the RBA mentioned in its last Statement on Monetary Policy was a scenario “in which the labour market and consumption growth are weaker than currently expected.” 13 13 Close Reserve Bank of Australia: “Statement of Monetary Policy,” 2/7/19. Recent consumption and labor market data has shown some downside surprises. The latest labor market data released in January showed an upside surprise in overall jobs gained, but underneath the surface the data showed a fall in full-time jobs and a larger increase in part-time work. This shift in the composition of the jobs gained will be worth watching to see if full time employment continues to lag – a potentially worrisome sign. If the labor market continues to show gains, notably in full-time jobs, it could reduce downside concerns.

Eurozone Manufacturing and Services PMIs (Thursday) Preliminary Eurozone PMIs for February will be released amid noticeable deceleration of economic momentum in Europe. Recent manufacturing and services survey data have disappointed expectations fueling concerns of a deeper-than-anticipated slowdown, beyond the frequently-cited one-off drivers of last year’s weakness. These drivers include regulation-related disruptions in the auto industry, political tensions in Italy and France, and environmental anomalies. While all of these drivers are likely contributors, deceleration in Chinese demand may be at the heart of the European slowdown. The European Central Bank has acknowledged the deceleration and turned slightly more dovish in response to it. Yet, the central bank maintains a relatively optimistic medium-term outlook under the assumption that the recent slowdown will be temporary. A new round of PMIs will shed some light on the extent of the European deceleration.

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