Carry Trades, an Attractive Portfolio Strategy
Carry trading, which has put the Swiss franc and the yen under pressure while it has benefited higher-yielding currencies, should make up a considerable portion of every investors’ foreign exchange portfolio. Joe Prendergast, head of Foreign Exchange Research at Credit Suisse explains why.
Joe Prendergast: Carry trading involves the borrowing of, or selling of a low-yielding currency and buying of a higher yielding currency. It is a very well established strategy in foreign exchange. Because we’ve had pretty quiet markets and relatively low market volatility in recent years, that strategy continues to grow in favor.
head of Foreign Exchange Research at Credit Suisse
Who is behind these carry trades?
It’s actually a pretty broad range of investors who are involved in this type of cross-country carry trading; from a private individual, to a hedge fund or a large institutional investor. One must note that these groups tend to execute the trading in a slightly different way.
Would you recommend an average investor to invest in carry trades?
Carry trading is very attractive as a theme, and of course it’s not new. In the last 30 years there has been a tremendous amount of academic literature supporting the idea that the return on offer to the carry trader - the excess interest rates in a foreign country over your own - does on average tend to more than compensate for the currency risk. As part of a portfolio of strategies, we would certainly recommend that this be part of any investor’s themes.
How big should this proportion of carry trades be in a portfolio?
That very much depends on the individual investor and also depends on the amount of time the investor wishes to spend on the portfolio. Carry trading is a default position in terms of currency trading, meaning it should be a fairly large component of a currency position, unless you are going to be a very active investor and spend a tremendous amount of time on macro research or technical analysis.
Can investors expect above-average return thanks to carry trades?
Historically, we’ve seen carry trading in foreign exchange deliver very strong returns over time, occasionally characterized by some draw downs as we see at this moment in time. However, those draw downs have often offered the best opportunities to enter into carry trading. It’s actually much more preferable to enter at times of market volatility, than at times of extreme market euphoria or complacency. We are speculating when answering the question, but we would certainly expect from this vantage point, carry trading to deliver very positive returns going forward.
Which are there currencies which have weakened due to carry trades?
The Swiss franc and the yen certainly both have suffered in recent year from the fact that they have relatively low interest rates. How much of that is down to speculative carry trades is certainly debatable. In the case of Japan we’ve seen lots of domestic capital outflow in reaction to the normalization of the financial system after the crisis of the past decade or so. That is not really speculative carry trading as we would define it. There’s definitely been some element of carry trades, but there is also significant fundamental macroeconomic support for the softness of both currencies.
Could you cite a few currencies which have benefited from carry trades?
The higher yielding currency block - the Australian and New Zealand dollar, the British pound and across to the Brazilian real or Turkish lira - have all strengthened in recent years largely due to their relatively high yields. This of course continues to be a support for those currencies, even if the interest differential has come down in recent years.
Can we say that investors are unwinding their carry trades now, when the stock markets are tumbling, and that is the reason the franc and the yen have been appreciating in the past week?
Yes, the market activity we see right now reflects some generalized unwinding of risk which would include carry trading, as much as any other risky or speculative activity. Both the Swiss franc and particularly the yen have appreciated significantly, all be it from very weak levels by historical standards.
How much could the Swiss franc and the yen still appreciate?
The franc and the yen could still gain a little bit further in the near term, if we continue to observe risk reduction. They are the two currencies that would continue to see some benefit in that environment. But we don’t think we’ll see very significant further gains, because the backdrop globally is favorable to risk absorption throughout the year. The still low interest rates, even they though may rise in both countries, will continue to make them attractive as funding vehicles for the medium-term.
Still much scope for hedge fund to unwind their carry trades?
There are certainly carry trades still in existence, meaning these could be unwound. But when you look at what has truly changed in the market environment in the year to date, what we see is the unwinding of some of the market euphoria we had in January. Back then, the market had a very complacent behavior. That vulnerable bit has now unwound. We don’t expect really significant further unwinds from here, though there is no doubt there will still be some. We don’t think the unwinding of carry trades will be a generalized medium-term phenomenon of risk reduction.
How about the U.S. dollar and the euro? How do you see them developing during the course of 2007?
The euro versus dollar has been relatively stable throughout this market volatility. Throughout the past year, Credit Suisse expected the dollar to hold up quite well supported by relatively high interest rates. What we’ve seen in recent months is a quite significant deterioration of the interest differential in the U.S.’s favor. That has contributed to some dollar softness that we didn’t anticipate. But the dollar held up quite well in the market movements of the past week, while the euro has perhaps suffered disproportionately. That reflects the fact that the euro was on the long-side of several carry positions out of yen built up over the last year or two. We think that the dollar will hold up fairly well in the current market environment, supported by relatively high interest rates. But it may not do as well as we would have thought it might last year.
