Could conditions be better for the carry trade?

>> Why is the yen so weak?

Better still, the prospect of policy easing offers the hope of price appreciation for those that hold short-dated bonds as part of their carry trade. Sitting atop all of this is the icing on the cake, which is rock-bottom volatility, especially in the FX market. What’s not to like? The problem, of course, is that, if it seems too good to be true, it probably is.

Successful carry trades require low funding rates, low volatility and wide rate differentials. Funding rates remain low in Japan even after the recent rate hike from the BoJ while funding rates in Switzerland have come down once and will likely fall further this year making it an even more attractive funding currency for the carry trade.

The SNB does not have an aversion to a weaker franc now that inflation has come down, although the BoJ is clearly unhappy about yen weakness. But the saving grace for the yen-funded carry traders is that BoJ intervention to lift the yen is, at best, only able to stabilise the currency. It seems unable to generate lasting strength, and hence those carry traders who are prepared to ride out bouts of BoJ intervention have likely benefited.

The second component of successful carry trades, low volatility, is also in place, with the tiny 1.05-1.10 trading range that has held euro/dollar in place for much of the last 18 months probably responsible for much of the volatility deficit across most currencies. The fact that the Fed is almost promising that its rates won’t rise again just adds another layer of low-volatility comfort. And even if the Fed does not ease, other central banks will, and this is also consistent with low volatility.

The reason for this is that easier monetary policy generally lowers the rate of return on assets, such as bond yields and dividend yields in the stock market. The return in the options market comes from the premium earned by option sellers. This premium is primarily driven by the level of implied volatility, and if the options market mimics the decline in returns that we see in other assets as central banks ease, then implied volatility should be falling.

If we turn to the third component; the asset side of the carry trade, we see wide differentials given the policy tightening that has been undertaken in recent years, and, better yet, the move to an easing cycle offers up the prospect of price appreciation for those that choose to make short-dated bonds the focus of their carry trade.

Unsurprisingly, all of these factors have made the carry trade a real winner, even in a G10 currency context; something that could not always be said about the period between the global financial crisis and the pandemic when policy rates and yields were uniformly low.

>> Switch carry funding

So, is the carry trade party likely to continue? Here we have to ask ourselves about the events that could upend the carry trade. For instance, from a funding perspective, a sharp and unexpected rate hike from the BoJ could cause the carry trade to wobble, but this seems unlikely. Sudden success in FX intervention that propels the yen to much higher levels could also strike a damaging blow to the carry trade, but, this too, seems unlikely.

Steve Barrow, Head of Standard Bank G10 Strategy said the biggest risk comes from a sudden surge in global risk aversion that both undermines riskier currencies and leads to a surge in volatility. But barring some unforeseen event, this too seems unlikely, at least in the coming months. However, if we want to look out a little further, to the US election, for instance, the chances of a switch to a more risk-averse environment seem greater.

“The Fed might have to forgo its no-rate-hike bias if the winner of the US election plots a much easier fiscal path. In short, carry-traders are “safe” for a few months, but if positive returns can be locked in before Q4, then investors should do so”, said Steve Barrow.