Eric Burroughs

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The carry trade never dies

April 11, 2011
AUD | BOJ | carry trade | ECB | Fed | FX | IDR | JPY | USD | yen

It never does, and believe me I know after covering the biggest one ever from 2005-2008 while stationed in Tokyo (see PRDCs). Yes, bouts of volatility will spark carry trade unwinds. Some unwinds are bigger than others, with 2008 being the mother of all carry trade unwinds. But the simple fact is that using cheap funds to buy other stuff – even just higher-yielding currencies – is a bonafide strategy that works well over time, and only except in the most extreme cases of volatility. Of course there are risks, as with any strategy, and you would want good warning signals on when to unwind to beat the crowd rushing for the exits at the same time.

Still, this yen carry trade is likely just in the beginning stages. Our BOJ sources have said they are worried about a suddenly weak yen at a time when Japan is needing to import even more energy and stuff for reconstruction. Let’s see. At the end of the day, the BOJ is underwriting another carry trade. So is the Fed. The ECB’s rate hike – whatever you think about hiking rates while the third euro zone member in the past year is getting a sovereign debt bailout – has underscored how the Fed is going to lag, and that means the dollar remains a carry funding currency.

Should we blame the BOJ and Greenspan/Bernanke put? Maybe. Is this sustainable? As long as the Fed and BOJ together remain central banks that take a very go-slow approach to tightening policy, and keep underwriting the carry trade. Remember, carry trades don’t simply mean borrowing the yen alone and selling it for a higher-yielding currency or some other asset that’s going up.

Typically they are done in basket form so as to limit the impact from individual currencies on the overall return profile. This is not rocket science, entirely. The Powershares DB G10 Currency Harvest ETF gives any retail investor exposure to this trade. Not surprisingly, the three funding currencies – pretty much equal-weighted at a third – are the USD, JPY and CHF and the longs are AUD, NOK and NZD. But this simplistic ETF doesn’t really replicate what you can do with a proper carry basket strategy.

Using the Thomson Reuters carry trade calculator, one I’ve looked at is a 50-50 short yen and dollar funding with a long Aussie and Indonesia rupiah. Simple and relatively liquid: you really only have to worry about the IDR leg in terms of liquidation. Great yield just using one-month AUD and IDR deposits, and something of a hedge by funding in both yen and dollars. The returns? The carry trade revival this year has driven it up 7.2 percent on a Sharpe ratio of 3.3 – not like crazy commodities, but better than most equities and not too shabby. Overlay that on a long commodities or equities strategy and you’re talking chunky returns – and very leveraged returns (so hedge with out of the money equity or FX puts) – in a volatile year.

Even more impressively, this simple strategy delivers over time. From the start of 2006 to the end of 2010, and so including the hit from the financial crisis, this play was up 36.7 percent on a Sharpe of 3.5 (and any Sharpe ratio – the risk/reward profile versus a given risk premium, so a bigger ratio is better – above 2.0 is pretty good). Over that time the MSCI APXJ was up 63 percent and the S&P 500 a mere 1 percent.

AUD-IDR carry trade 2006-2010

From 2001 through 2010, this JPY-USD short versus a AUD-IDR long was up 162 percent, uncovered interest rate parity be damned.

At the moment, the rupiah is a great play too because the central bank is giving every indication of being happy to let currency appreciation be the main tool for tightening policy and seeing it as a bulwark against imported inflation, even as Indonesia’s already high rates are likely headed even higher. With the Aussie, the potential case for even higher rates is clear, growing and not fully priced in.

There are of course clear risks in the near-term from very crowded trades, especially in yen crosses. But sticking with the carry trade should pay unless we face another severe economic shock, with China being the biggest risk. What folks forget about the carry trade during the financial crisis is that the Lehman Brothers demise and the severe recession it wrought was the real death blow. Until then, the yen carry trade was holding up just fine.

The carry trade is not some nefarious device driven by FX speculators. It’s a fairly sensible strategy. More to come on this.