LONDON Hedge funds think 2014 could be the year their currency bets finally pay off, after getting burned last year on trades ranging from the Australian dollar to the greenback.
The influence of central banks and competition among nations to weaken their currencies to boost economic growth made 2013 a year to forget for many funds. The average macro currency fund was up just 0.42 percent in the 11 months to November, according to Hedge Fund Research.
But many funds have recently pumped up their bets again in the belief that trends - which they can bet on - will reappear in currency markets as different countries' economic growth and interest rates take diverging paths.
"Globally, currencies and fixed income have become more interesting, given the differing paths of regional growth and the (Federal Reserve) versus the ECB and versus other central banks," said Anthony Lawler, portfolio manager at GAM, who said funds are placing bigger bets on currencies than six months ago.
"As such, we expect to see stronger returns in currencies and rates trading."
Here are five top bets that hedge funds are pursuing for 2014:
1) Long dollar versus yen.
The biggest bet is also the one that proved most lucrative last year, delivering 21 percent thanks to the Bank of Japan's ultra-loose monetary policy.
Now the Federal Reserve's tapering of its bond-buying programme has finally begun, a move likely to boost the dollar as investors are attracted to higher Treasury yields. And with the Bank of Japan expected to provide even more stimulus this year, hedge funds expect this trade to keep on delivering.
"The whole driver (this year) is going to be yen. If you're only a USD guy and you're ... only in euro/dollar, you're going to get a whole lot of nothing," said Aaron Smith, managing director at currency hedge fund firm Pecora Capital, who said the yen was his heaviest weighted currency pair.
The Commodity Futures Trading Commission's Commitment of Traders (CoT) report shows leveraged funds' short bets on the yen are around three times the size of long bets.
2) Short Australian dollar versus U.S. dollar or New Zealand dollar.
After a huge bull-run in the wake of the credit crisis that took it well above parity with the U.S. dollar, hedge funds have rushed to short the Aussie in the belief it will suffer as China's demand for commodities cools.
But the path down has not been steady and "people got really burned" in recent years, says Anne-Gaelle Pouille, managing director and partner at fund of hedge funds firm PAAMCO.
Nevertheless, the trade has paid off well in recent months and particularly last week, as the Aussie slumped to its lowest versus the greenback since mid-2010.
One star manager to benefit is CQS founder Michael Hintze, who has cited the "very, very clear" wish of central bank governor Glenn Stevens for the Aussie to weaken.
The Aussie also hit an eight-year low against the Kiwi last week, as large macro funds sold. Hedgies like the trade because of the prospect of lower interest rates in Australia and higher rates in New Zealand.
3) Long sterling versus the euro.
"Sterling remains a darling of mine," says Savvas Savouri, chief economist at hedge fund firm Toscafund.
The pound was one of the surprise packages in the second half of last year as the UK's economic resurgence brought forward expectations of an interest rate rise.
While inflation has fallen back to the Bank of England's target and many commentators expect the Bank to lower the threshold at which it considers a rate hike, the UK is nevertheless seen on the tightening path, in contrast to the euro zone, where disinflation remains a concern.
According to the Newedge Trend Indicator - a model portfolio that replicates the trades computer-driven trend-following funds might make - these funds have been long the pound for 158 days.
4) Long dollar versus the Canadian dollar.
Another very popular bet with hedgies, this has paid off as the loonie hit a four-year low last week, after data showed the country unexpectedly shed jobs last month.
The CFTC's CoT report shows leveraged funds' shorts bets on the loonie outnumber long bets by more than four to one.
5) Long Mexican peso versus emerging market currencies.
Managers are split on the outlook for emerging market currencies as they try to assess the impact of Fed tapering.
But many like the Mexican peso, thanks to the country's strong growth and improved credit rating. Last month London-based Macrosynergy Partners said in a letter to clients, seen by Reuters, that they had put a long position back on in the peso.
While funds consider the dollar too strong a currency to bet against, trades against the currencies of slower-growth emerging markets look more tempting.
"The Mexico peso is (our) favourite overall because of the ongoing reform process, especially on energy, and the implications this has for stronger foreign direct investment and other inflows into Mexico, as well as the impact on potential growth," said Ian Gunner, manager at Altana Hard Currency Fund.
(Reporting by Laurence Fletcher; Editing by Mark Trevelyan)