Does carry trade suffer from rising rates? - Natixis

Su Young Lee, Research Analyst at Natixis, explains that as the Fed has started and will continue to normalize its monetary policy in the coming months (Natixis expect 3 more hikes this year in June, September and December), Natixis looks at simple and well-known simple FX carry strategies and study their performances during US bond sell-offs periods.

Key Quotes

“We look at recent past episodes where the increase in UST 10Y rates exceeds 100bp, and look at the returns of carry trade portfolios.”

“We study both G10 and EM carry trade strategies, using monthly returns. We study two different EM strategies. The first strategy is a simple strategy that is widely practiced: long EM currencies and short USD, i.e. funding the position with USD. The second strategy is a long/short portfolio going long (short) the 4 EM currencies with highest (lowest) discount rates are chosen for long (short).”

“We find that during restrictive periods in general, carry trades perform better than simple long USD position (against all currencies in this study) but EM currencies do not necessarily outperform G10 currencies, when the strategy above is adopted. In Asian EM, this strategy in fact yields negative returns during restrictive periods, and improvement in volatility is not observed. Returns generated from simple forward trades with G10 currencies have been also greater during the periods of rising UST 10Y rates.”

“The EM Long/short portfolio has lower returns during the four periods of US interest rate increases than during the entire sample, but the volatility was well contained at an average level when 10Y yields rose.”

“Another important factor in determining carry trade profits, especially when the maturity is a mid-long horizon, is the volatility. If rate differentials are large but the volatility of the currency is high as well, carry trades may not be as profitable as it looks. Ratios between implied interest rate and implied volatility therefore can give an approximate view on actual carry profits via options.”

“While the overall ratio between forward rates and volatility has been decreasing post-crisis, EM countries still have higher ratios than G10 countries. Especially with recent major political risks occurred in developed markets, forward rate/volatility ratio of G10 countries has remained at a very low level compared to that of EM countries. Such risk dynamics makes EM currencies interesting on a relative basis.”   

“Bottom Line: FX carry trade portfolios did deliver positive excess returns during periods of rising US. Not surprisingly, EM currencies, especially LatAm currencies, have better returns than G10 in both simple long-only and long/short strategies. Long/short strategies outperform simple long-only strategies, by capturing the essence of carry trade (i.e. rate differentials), and by lowering the exposure to short USD position. Moreover, looking at the ratio between forward interest rates and FX volatility another metric of carry attractiveness, EM currencies have a much better profile. Post-crisis, increases in volatility and easing policies by central banks, however, mark overall lower risk reward for both EM and DM carry trades.”