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Analysis: Asia FX carry trade returns but hostage to volatility

A pedestrian is reflected in an electronic board showing exchange rates between the Japanese yen against the euro (top L to bottom), the yen
A pedestrian is reflected in an electronic board showing exchange rates between the Japanese yen against the euro (top L to bottom), the yen

By Vidya Ranganathan

SINGAPORE (Reuters) - The currency carry trade is making a slow comeback in Asia although, unlike its popular pre-crisis version, punters are more selective in their investment targets for fear that market volatility could leave them with losses.

This time, carry traders are eschewing traditional high-yielding currencies such as the Australian dollar, Indian rupee and Indonesian rupiah in favor of the stability of the Singapore dollar and Chinese yuan.

The most speculative short positions in the yen since 2007 and a rising Singapore dollar provide hints that this form of currency trading is returning.

The carry trade involves investors selling short one currency and buying assets in another currency to lock in the yield differential, or 'carry'.

The trade was widespread before the global financial crisis as investors sold the low-yielding yen to invest in higher yielding currencies. Money flooded into New Zealand's dollar, raising concerns among policymakers at the time that it could destabilize the small economy.

"It's structurally different now compared to what it was pre-2007," said Geoff Kendrick, head of emerging markets FX strategy at Morgan Stanley in Hong Kong.

"Then you had investors reach for yield, which resulted in large carry positions in FX. It was at that stage much more of a buy-and-close-your-eyes kind of trade."

Now investors are wary of volatility, Kendrick said, citing the rupee, which slumped to a record low against the dollar this year. "It has a very strong carry and yet the market is being much more nuanced," he said.

Unlike before the global financial crisis, many Asian currencies are now extremely volatile. Big swings in the currencies used in the deal could wipe out returns, which tend to be modest on most carry trades.

The carry trade vanished when global central banks flooded markets with cheap money to fight the 2008 financial crisis, spurring huge rallies in emerging market stocks and bonds.

With the U.S. Federal Reserve preparing to start winding down its ultra-loose monetary policy, investors are now looking for alternatives to stocks and bonds, which many reckon are overvalued.

Furthermore, analysts expect many Asian currencies to remain volatile in coming months because of looming changes in monetary policies globally and uncertainty over how far and how fast U.S. dollar yields will rise as the Fed reduces stimulus.

CHANGED LANDSCAPE

The yen and Swiss franc have traditionally been the funding currencies for carry trades, although the U.S. dollar has become one since 2008 because of ultra-loose U.S. monetary policy.

The yen remains the carry traders' funding currency of choice as the Bank of Japan's massive economic stimulus program weakens the currency and makes it extremely cheap to borrow. The yen has already fallen to more than 102 per dollar from around 86 at the end of 2012.

Yen short positions hint at a spurt in carry trades. Speculators' net short positions rose last week to 133,383 contracts, the highest level since July 2007.

While analysts say the yen is a long way from its hey day as carry trade favorite and not all short positions are connected to carry trades, cross currency rates suggest that some of the yen is funding what seems on the face of it to be unusual purchases.

For instance, the Singapore dollar is rising against the yen but the Indonesian rupiah, which has among the highest yields in Asia, is not.

The Singapore dollar has risen to 82.5 yen, its highest level since 1999. Typically, investors would buy the short-term bonds in the target currency, but in Singapore's case the return is modest. Three-month bills yield just 0.25 percent, for example.

While yields in similar bills in Indonesia would bring in 6.6 percent, the currency has been much more volatile, and that pushes up the hedging cost. The rupiah has dropped 20 percent against the yen since May and 60 percent since mid-2007.

"People aren't going for whatever has carry," said Mirza Baig, head of rates and FX strategy at BNP Paribas in Singapore.

"And the way they are differentiating, it means they expect volatility will pick up. It's more a selective revival in carry trades, based on improving fundamentals."

The Singapore dollar and Chinese yuan offer low volatility and the promise of gradual appreciation, even if their bond yields are in low single digits.

The reason investors like to stay invested in the yuan is not the yield but China's massive trade surplus that keeps pushing the currency higher, analysts said. A government reform agenda has added to the allure of the yuan in the hope that it will allow the currency to appreciate faster.

By contrast, investors would have to hedge other carry trades in Asia. And the yield on one-year bonds minus the hedging cost is just 71 basis points (bps) in South Korea and 20 bps in India.

In Indonesia, the hedging cost is 170 bps more than the bond yield. Likewise, hedging would wipe out the nearly 3 percent carry offered in one-year Thai bonds.

"To get that full 300 bps of yield, you've got to be able to sit in that currency for an entire year," said Ray Farris, head of Asia-Pacific strategy research at Credit Suisse in Singapore.

"In the first month of the trade, you accrue about 25 bps, which is not even a single day's currency volatility. It's hard to call that stuff carry trades."

PSEUDO-CARRY

The New Zealand dollar, or kiwi, has rallied more than 11 percent against the yen since October, but the currency's yield belies the traits of a carry trade. Rates at record low 2.5 percent are a quarter of what they were in 2007.

And although the central bank is expected next year to raise policy rates, that is fully factored into the currency's level, traders say.

"This situation is more of a pseudo-carry trade rather than the prototypical carry trade," Neal Gilbert, market strategist at Gain Capital in Grand Rapids, Michigan. Investors were betting on a weakening yen through this trade and the interest earned was merely an added benefit, he said.

In any case, wholesale interest in carry trades will not return so long as there are more profitable opportunities in equities and credit markets, said Kendrick.

"The simple things are still working. There's still easy wins in that space as opposed to leveraging up and going long carry in the FX space," he said.

(Additional reporting by Lisa Twaronite in Tokyo; Editing by Nachum Kaplan and Neil Fullick)

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