FX carry could survive in uncertain times

NEW YORK (Reuters) - A strategy to invest in high-yielding assets from developed economies using low interest rate currencies in so-called "carry trades" could still work in 2010 despite worries about the euro-zone debt crisis.

Carry trades tend to thrive in periods of economic expansion and low volatility and inflation. But during periods of uncertainty, these bets can be profitable, though require investors to be more nimble. If the situation in Europe deteriorates further, or any exogenous shock hits financial markets, profiting becomes harder.

Steven Englander, global head of FX strategy at Citigroup, said at the Reuters Investment Summit in New York that the bank's portfolio is "modestly long" higher-yielding currencies such as the Norwegian crown and the Australian, Canadian, and New Zealand dollars against the euro and yen.

The funding currencies in these trades are the euro and yen, which have rates of 1.0 percent and 0.1 percent respectively. Borrowings in the euro and yen are used to buy the Australian and New Zealand dollars, which have interest rates of 4.5 percent and 2.75 percent, two of the highest in the world. The Bank of Canada, on the other hand, has embarked on a tightening cycle. Canadian dollar rates have risen to 0.5 percent and are expected to keep going up.

"The reason we're confident about our risk trade is because there is no policymaker out there facing a double-dip recession in asset markets or in their economies," Englander said. "Moreover, policymakers will be very active in preventing a double-dip from occurring."

Englander says Europe will survive the crisis. He said in recent research that while many say the recent financial market crisis has damaged growth prospects, Citi's economic surprise index and other measures of confidence remain high for the euro zone.

STEADY EURO ZONE ECONOMIC INDICATORS

Even for the weakest of the euro zone countries, Englander said leading economic indicators have not "fallen out of bed," adding that the composite for Spain, Portugal, Greece and Ireland remains relatively firm and well above the lows of 2008.

Stable growth is important. If the euro zone were to slow further, rates would stay low, but volatility in the euro would increase, making it harder to profit from carry trades.

In addition to his call about a "no double-dip recession" in major global economies, the Citi strategist also pointed to low inflation in the Group of Three developed economies -- the United States, euro zone, and Japan, which should support carry trades.

Goldman Sachs' senior U.S. investment strategist Abby Joseph Cohen shares Englander's view on the global economy.

She said the United States is not facing a double-dip recession, with equities, another high-risk asset, expected to do well given low inflation.

An S&P 500 index level of 1,250-1,300 points .SPX "is fair value and achievable" over the next six to 12 months, Cohen said. On Thursday, the S&P 500 closed up almost 3 percent at 1,086.84.

Even the euro zone will be able to deal with the region's debt crisis, Cohen said, because there is "sufficient political determination" to ensure it survives.

In emerging markets, meanwhile, Barclays head of emerging market strategy Michael Gavin said valuation strategies -- determining which currencies are undervalued or overvalued based on certain metrics -- are more important in these uncertain times.

He likes most Asian currencies, which are undervalued by most measures, such as the Korean won. Amid tensions between the two Korean nations, the South Korean currency has been hammered in 2010, with year-to-date losses against the dollar of about 6.6 percent after gains of more than 8 percent last year.

But Gavin said the South Korean economy is moving toward full employment, boosting its economic outlook. He estimates that the U.S. dollar/Korean won exchange rate could hit 1,025.00 in 12 months. On Thursday, the currency pair strengthened by 0.3 percent to 1,250.40.

With respect to other currency investment strategies, Gavin doesn't think carry trades would work for emerging markets currencies given the expectation of more "shocks" out of Europe. Gavin says the euro-zone crisis has yet to be fully priced in emerging markets.

(Editing by Padraic Cassidy)