Wednesday 31, May 2017 by

Don't say you haven't been warned .... the Carry trade is almost full

By BP Consulting

"History Says Emerging-Market Carry Trade Can Only End in Tears." - Bloomberg Markets

Our thanks to Bloomberg for bringing us Bank of America Merrill Lynch's assertion that investment in the carry trade - that ever-so-popular trading strategy that entails borrowing in low-interest currencies to invest in high-yielding ones -- is entering dangerous territory. Our thanks too for reminding us of Harvard economist Jeffrey Frankel's much-quoted observation that participating in the carry trade was "like picking up pennies in front of a steamroller".

For those not involved, the concept of nicking comparatively small returns at the risk of getting caught out by some major market reversal may not make sound economic sense. But the returns available in those high-yielding currencies at such low costs of funding are irresistible for many traders -- the trick of course is NOT to get caught out still in the trade when things change. As John Hardy of Saxo Bank puts it: "You want to be the first out, not the last". You've got to back your ability to recognise an approaching switch in sentiment."

Plainly, an awful lot investors have that confidence (though they cannot all be right). Global emerging-market debt funds have attracted inflows for 17 weeks in a row, taking the total inflows to over $33 billion. The average return on those funds has been 7.5 per cent year-to-date according to Bloomberg's FX Carry Trade Index, which compares pretty favourably with the near-zero rates on offer in the US and Europe. So it's all been going well, aided by almost unprecedented low levels of volatility and a US Dollar that has comprehensively failed to match the bullish projections held for it at the turn of the year.

The low volatility factor has been key.... a "risk-off" environment, with investors aggressively seeking safe-havens, would obviously not be one where you want to be in those riskier currencies. And just as obviously the carry trade (which in its simplest form requires you to borrow in a low-interest rate major currency, sell that currency and buy an emerging-market currency to invest at higher yields) by definition leaves you with a short major currency / long EM currency open FX position. So it's just as well that the markets have welcomed the political developments in Europe, and displayed remarkable sangfroid about the political situation in Washington..... so far, at least.

But B of A now reckon that we're close to a bit of a reckoning. Too many people are in on the same act and positioned the same way ..... which makes them vulnerable. "Carry trades are notorious for risk-off unwinds, especially when positioning is crowded and correlated", and according to B of A's Emerging Market Carry-Sentiment Indicator (we swear, there is an Index or Indicator for everything these days), we are fast approaching the levels that historically have preceded a major correction. The suggestion is that it's time to take your profits and exit the trade while you can still easily do so - the current conditions that have so benefitted the carry trade are unsustainable.

Well, it's a point of view..... though not supported by everyone. Goldman Sachs for one are of the opinion that conditions will remain supportive and that there is still a bit of mileage in the carry trade. But all traders should get a little nervous of any market getting overdone, and the possible storm clouds are still around: China's debt issues and its plans to deleverage, for instance. Or what about the possibility that US growth will return to a level that would increase the rate of monetary tightening?

Essentially, and without putting words in their mouth, B of A's message is : "listen, you've all done nicely but things are beginning to look a bit dodgy.... time to let discretion be the better part of valour".

One thing we can be sure of though is some traders will have more discretion than others.

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