Carry trades are back: "fragile five" in demand at euro's expense

LONDON, April 9 Wed Apr 9, 2014 9:06am EDT

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LONDON, April 9 (Reuters) - Borrow-low, invest-high carry trades in foreign exchange markets are back again after a bad few months, as anticipation of a U.S.-led global recovery lures investors to return to risky emerging currencies, with the euro a likely loser.

In demand are the currencies of the "fragile five" countries highly reliant on foreign capital - the Turkish lira, the South African rand, the Brazilian real, the Indonesian rupiah and the Indian rupee.

All five were shunned for much of last year because of fears the winding down of U.S. monetary stimulus would see funds withdrawn from emerging markets.

But the options market indicates a rally may have legs, as gauges of how choppy the major currencies will be have fallen, encouraging investors to take on more risk in search of returns.

Such risk-seeking trades, in which investors borrow in a low-yielding currency to buy a higher-yielding one, are especially popular among nimble asset managers, speculators and hedge funds.

They have provided steady long-term returns but struggled in the first quarter of this year because of concerns about a sharp economic slowdown in China and a flare-up between Russia and the West over Ukraine, which could undermine a global recovery.

The biggest danger for the carry trade is volatility: the prospect that a sudden fall in the riskier currency will wipe out the profits from investing at a higher interest rate.

But such worries have eased somewhat, allowing investors to focus on monetary policy divergence and macro-economic trends.

While the U.S. Federal Reserve is gradually unwinding its bond-buying stimulus programme and expectations are it may tighten policy in the middle of 2015, the European Central Bank and the Bank of Japan are both pledging to flood markets with cash to support growth and avert the risk from deflation.

Last week, ECB President Mario Draghi flagged the chance of so-called quantitative easing (QE) as opposition from Germany's Bundesbank appeared to be waning.

QE increases a currency's supply and usually leads to a drop in its value and to a fall in the cost of borrowing in it, both of which are good news for the carry trade.

That should see the euro join the yen, and perhaps even replace the U.S. dollar, as preferred currencies for investors seeking to borrow at ultra-low rates.

"Calming geopolitical tension has allowed markets to refocus on monetary policy divergence and also on the carry trade," said Chris Turner, head of currency strategy at ING.

"The Fed's confidence in the recovery is clearly growing and the path to normalisation, and a stronger dollar, should continue. We prefer to fund carry in euros."

Investors are also buying the traditionally higher-yielding New Zealand, Australian, Canadian dollars and the Norwegian crown among actively-traded currencies, funding these by selling the euro, the yen and, to some extent, the dollar.

Speculators cut short bets against the Australian dollar in the week to April 1 by almost a fifth and remain positive on the New Zealand dollar.

The less-active emerging currencies have outperformed, with the Turkish lira and South African rand hitting three-month highs to the dollar and the Brazilian real at five-month highs this week. India's rupee touched an eight-month peak last week while Indonesia's rupiah is hovering near highs seen in October.

Those currencies had all seen massive sell-offs in the second half of last year, when rising U.S. bond yields, which hit two-year highs in September, prompted many investors to return to dollar-denominated assets.

CARRY ON AS VOLATILITY CRUSHED

After witnessing outflows of over $50 billion in the first quarter, global emerging markets equity funds received $2.5 billion in the week to April 2 while debt funds received just over $1 billion, according to data from EPFR, a Boston based fund tracker.

These inflows highlight the revival of carry trades, which have generated 5 percent annual returns in the past three decades, according to a 2012 study by the Cass Business School.

Societe Generale analysts say the revival of carry trades in recent days is showing promise. Their basket of G10 carry-trade currencies is showing returns of over 3 percent, year-to-date. An emerging-market carry-trade currency basket would have returned almost double that, they added.

With the cost of borrowing in developed economies like the United States, Japan, the euro zone and Switzerland close to zero and bond yields there anchored for the time being, the chance of making money in major currencies is limited.

Implied volatilities, derived from option prices, indicate currencies are unlikely to see sharp swings. The one-month euro/dollar implied volatility is at its lowest since mid-2007 while for dollar/yen it is near late 2012 troughs.

While volatilities could spike if doubts over global growth re-emerged, geopolitical tensions rose or the Fed tightened policy sooner than expected, for now they are expected to stay low, encouraging risk-taking.

The carry trade itself can add to volatility if panicked investors unwind their positions, but that is less of a worry now because the trade is only just starting to pick up.

"We are now only at the beginnings of a carry cycle and a spike in volatility is therefore unlikely to be position driven," said David Bloom, head of currency strategy at HSBC. "The best way to play this fall in volatility is to buy the high-yielding 'fragile five' currencies." (Editing by Peter Graff)

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