Carry trade gains traction as currency volatility turns lower

Bloomberg

Conditions in the $5.3 trillion foreign-exchange market have turned supportive for one of the most popular trading strategies — the carry trade.
Returns from the technique, in which investors borrow in currencies with low interest rates and use the proceeds to buy an asset with higher rates, advanced this week to the highest levels since December, according to a Deutsche Bank AG index. The results were aided by rallies this month of 4 percent for both South Africa’s rand and Canada’s dollar against the euro.
Carry trades lost the most last year since 2008 as China shocked global financial markets by devaluing the yuan and a rout in emerging markets sent potential carry purchases tumbling. In April, the strategy has been buoyed as volatility wanes while commodity prices stabilize, bolstering the currencies of countries offering relatively higher interest rates.
“We’ve had a very good run higher, a push by better risk appetite,” said Charles St-Arnaud, senior economist at Nomura International Plc in London. “And currencies have benefited from the carry trade,” he said, noting, “a lot of the pickup has been supported by higher commodity prices.”
Carry trade returns reached the highest levels this week since Dec. 7, according the Deutsche Bank G10 FX Carry Basket Index. Since April 1, 29 of the 31 major currency carry trades funded in euros have made money, the most since October, according to data compiled by Bloomberg.
Muted price swings this month have helped benefit carry trades, as JPMorgan’s Global FX Volatility Index fell to 10.95 percent, the lowest in four weeks. Options prices show one-month implied volatility, a measure of anticipated price swings for the euro-dollar rate, fell to 7.6 percent this week, the lowest since December 2014.
Fed Watch
Investors will be watching the Federal Reserve’s April 27 policy statement for clues about plans for interest rates this year. The odds in the futures markets of an increase in rates at the April 27 policy meeting has been pared to zero, down from 56 percent at the start of the year. The calculation assumes the effective fed funds rate will average 0.625 percent after the central bank’s next increase.
Some analysts suggest caution about the risks of diving back into higher-yielding currencies.
“How long the present carry-positive environment persists is the key question,” Oliver Harvey, macro strategist at Deutsche Bank in London, wrote in a note. “Fed pricing may be too dovish, and sluggish emerging-market growth may still persist, but the question is when either becomes relevant for markets.”
As global currency volatility has waned, emerging-market currencies have gained support, opening up opportunities for riskier carry strategies. Amid stabilizing commodity prices and speculation the Fed will take a slow approach to raising U.S. interest rates, investor Mark Mobius and Morgan Stanley & Co. see room for more gains.
“The strength in emerging-market currencies that started in January is set to continue over coming weeks with supportive inflows helping keep the asset class supported,” Morgan Stanley researchers including Gordian Kemen wrote in a note to clients. The bank recommends selling the dollar versus the Mexican peso and the Indian rupee.