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Most lucrative currency strategy borders on becoming Fed proof
[NEW YORK] Even a hawkish Federal Reserve may not be enough to slow down what has become the most profitable trading strategy in the foreign-exchange market.
Using the weakening US dollar to finance purchases of higher-yielding rivals this year has generated outsize returns during a period of relative calm elsewhere.
That's been especially true for emerging-market currencies, where the gains are the most since 2009, led by a jump in the Mexican peso.
As the greenback continues to flounder in the face of political disarray and stagnating inflation, US dollar-funded carry trades that benefit now from higher interest rates elsewhere should remain attractive even with the Fed signaling its intent to hike US rates for a third time this year, according to Steve Barrow, head of G-10 strategy at Standard Bank in London.
"The interest costs you incur from higher funding costs are offset by dollar weakness that I expect to continue," said Mr Barrow.
"The dollar won't get strong enough to offset the kind of interest you earn from the carry trade."
Helping to boost profits is the unusual phenomenon in which volatility in major currencies is exceeding that of emerging markets.
The spread between three-month implied volatility in developing nations and Group-of-Seven countries is the widest since February, according to data compiled by JPMorgan Chase & Co.
The subdued volatility has been a boon for emerging market carry trades, which have returned 12 per cent in 2017, according to Bloomberg indexes.
Meanwhile, Group-of-10 carry trades have lost about 4 per cent.
The profitability of the trade depends on the direction of the greenback, which has fallen roughly 10 per cent this year.
In a sign of how much sentiment has soured, speculators have the most net-short positions on the currency in four years, CFTC data show.
A string of disappointing US data and skepticism that the Trump administration will be able to ignite economic stimulus have weighed down the US dollar, which has lost ground against all of its G-10 peers this year.
Some investors and analysts say that the extreme positioning indicates that dollar bearishness has gone too far.
A Bank of America survey earlier this month found that money managers labeled the short dollar trade the second-most crowded bet in markets, just months after deeming long dollar the most crowded trade at the start of 2017.
Should the US dollar continue its descent, it will remain an attractive funding currency as the Fed hikes rates, says Hans Redeker, head of foreign exchange strategy at Morgan Stanley.
The cost of funding in the US dollar is unlikely to surpass the return in emerging markets, given that he forecasts developing nation economic growth to accelerate to 4.8 per cent.
"Emerging market ROIs are going up at a bigger rate than you see rate hikes," said Mr Redeker.
"The carry trade is going to stay very lucrative."