Carry Trades Show Limit to Central Bank Stimulus

FX volatility hits five-year low; carry trade profitability has declined.

The $4 trillion-a-day foreign-exchange market is losing confidence in central banks’ abilities to boost a struggling world economy.

Rather than sparking bets on growth, the JPMorgan Chase & Co. G7 Volatility Index, which more than doubled in 2007 to 2008 before policy makers employed extraordinary measures to address faltering global expansion, has dropped to a five-year low. While small foreign-exchange swings historically favor the strategy of borrowing in low-yielding currencies to buy those with higher returns, a UBS AG index that tracks profits from the so-called carry trade has fallen to the lowest level since 2011.

“At this stage it may feel frustrating, but waiting is not a bad strategy,” Mauricio Bouabci, a London-based currency fund manager at Pareto Investment Management Ltd., which oversees $45 billion, said in an Oct. 17 telephone interview. It would take increased volatility to tempt him back into the market, he said.

Foreign-exchange speculation is declining as mandated spending cuts and tax increases in the U.S. next year, concern that European government leaders aren’t moving fast enough to fix the region’s debt crisis, and slowing growth in emerging economies from China to Brazil weigh on sentiment. The world economy will expand 3.3 percent this year, the least since the 2009 recession, the International Monetary Fund said on Oct. 9.

Average daily volume in foreign exchange fell 39 percent in September from a year earlier, according to data from ICAP Plc’s EBS trading platform. That’s also harming currency managers’ efforts to boost returns.

The UBS V24 Carry Index surged 4.55 percent in the first quarter, the most since 2009, amid optimism the economic recovery was gathering pace. It ended last week at 428.71, down 7 percent from this year’s high of 461.01 set on Feb. 29.

The gauge has fallen 4.8 percent from a level of 450.15 on Aug. 9, before the Federal Reserve said it would buy $40 billion of mortgage debt a month until it sees improvement in the U.S. economy, the European Central Bank said it would buy bonds of indebted members that ask for aid and the Bank of Japan boosted its asset-purchase fund to 55 trillion yen ($690 billion). The JPMorgan volatility index fell to 7.47 percent on Oct. 15, the least since October 2007.

“Low volatility is something that participants haven’t felt comfortable with for a while,” Adrian McGowan, head of foreign-exchange forwards, options and trading in Europe at Barclays Plc in London, said in an Oct. 12 interview. Investors haven’t been making “large” bets “because there has been so much uncertainty,” he said.


Real Weakness

The dollar fell 0.6 percent against the euro last week to $1.3024, and rose 1.1 percent to 79.32 yen as speculation the Bank of Japan will boost monetary stimulus sapped demand for that nation’s assets..

Investing the proceeds of dollar-denominated loans should offer easy profits because the Fed has said it’s likely to keep the target rate for overnight lending between banks near zero through mid-2015. The carry trade can lose money when the currency used to fund the strategy strengthens, or the targeted currency weakens, or some combination.

Selling borrowed dollars to buy reais in Brazil, where the target interest rate is 7.25 percent, has lost about 3.4 percent this year as the real tumbled, according to data compiled by Bloomberg. The IMF says Brazil will grow 1.5 percent this year, instead of the 2.5 percent predicted in July.

Borrowing euros and using the proceeds to buy the New Zealand dollar, where the official cash rate is 2.50 percent, produced an 8.2 percent loss since Sept. 6, when the ECB’s pledge to offer Spain assistance helped trigger a slump in three-month implied volatility for the pair.

“Carry had such beautiful, fantastic returns -- so alluring, so attractive that I think people got hooked on it like a drug,” David Bloom, global head of currency strategy at HSBC Holdings Plc in London, said in a telephone interview on Oct. 19. “In today’s zero interest-rate policy world, peppered with unconventional policies, it is much more difficult and confusing,” he wrote in an Oct. 12 research report.

Signs of strength in the global economy have emerged, including gains in jobs, consumer confidence and retail sales in the U.S., the world’s largest economy.

The Citigroup Economic Surprise Index for the Group-of-10 countries, which measures when data is beating or trailing the forecasts of analysts, climbed to a seven-month high of 18.4 last week, from this year’s low of minus 56.2 on June 26. The MSCI All-Countries World Index of shares has jumped 15 percent from this year’s low in June.


Smaller Margin

“There are still carry opportunities, but they are not as big as they used to be so your margin of error to get in is smaller,” Brian Kim, a currency strategist at Royal Bank of Scotland Group Plc’s RBS Securities Inc. in Stamford Connecticut, said in an Oct. 17 telephone interview.

The Bloomberg-JPMorgan Asia Dollar Index has climbed 2 percent this year, while the Mexican peso strengthened more than 8 percent against its U.S. counterpart.

Doubts about the strength of the global economy flared on Oct. 19. U.S. stocks slid the most since June as companies from General Electric Co. to McDonald’s Corp. and Microsoft Corp. posted earnings below analyst estimates and euro-area leaders failed to discuss aid for Spain at a summit.

Earlier in the day, China’s Ministry of Commerce said foreign direct investment in the world’s second-biggest economy, fell 6.8 percent in September from a year earlier to $8.43 billion. China’s economy expanded 7.4 percent in the third quarter, the weakest pace in more than three years.

In reducing its forecasts for 2012 and 2013, the Washington-based IMF said it now sees “alarmingly high” risks of a steeper global economic slowdown, with a one-in-six chance of growth slipping below 2 percent.

At the same time, the U.S. faces $600 billion in automatic spending cuts and tax increases starting Jan. 1 if Congress can’t agree on ways to reduce the deficit. Economic output would shrink by 0.5 percent next year, and joblessness climb to about 9 percent if the so-called fiscal cliff isn’t averted, according to the Congressional Budget Office.

Policy makers from Australia to Sweden, who had kept interest rates high as their economies grew, are lowering borrowing costs, reducing the allure of carry trades.


Rate Cuts

Australia’s central bank cut rates five times in the past 12 months. The Aussie’s appeal to global investors has flagged, falling 3 percent to $1.0311 since mid-September, as the spread between 10-year Australian and U.S. Treasury yields narrowed to 1.42 percentage points on Oct. 19 from 2.32 percentage points a year earlier.

Rates may be cut further, according to the minutes of a Reserve Bank of Australia meeting on Oct. 2. Sweden’s Riksbank lowered borrowing costs in September, predicting growth will slow to 1.5 percent this year from 3.9 percent in 2011.

Hedge funds focused on foreign-exchange trading have lost 0.6 percent in the past three months, according to industry researcher That compares to an average gain of 1.9 percent since June for the industry.

Trading ranges for currencies have narrowed across major pairs. The average daily percentage change of the Australian dollar versus its U.S. counterpart has declined to 0.47 percent in 2012 from 0.68 percent last year, while for the real it has shrunk to 0.51 percent from 0.72 percent.

“We are likely to stay in an environment of low rates for longer,” Morgan Stanley currency strategists led by Hans Redeker in London wrote in an Oct. 18 research report. In such an environment, potential returns from carry trades are “likely to be limited,” they wrote.


Bloomberg News


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