ESGE - The Currency Carry Comeback
2023-05-03 03:30:00 ET
Summary
- Carry is a strategy that uses forward contracts to mimic the capture of spread through borrowing in low-interest-rate currencies and investing in high-interest-rate currencies.
- Recession concerns and slowdown predictions have been mostly U.S.-centric, contrasting with projections for emerging markets.
- We believe that a thoughtful currency factor mix, risk management, and ongoing monitoring of the broader macro landscape are all important elements in seeking to capture the currency carry upside.
By Seth Tolev, CFA
With central banks signaling a pause to rate increases, currency carry has become a significant performance driver this year.
Carry is a strategy that uses forward contracts to mimic the capture of spread through borrowing in low-interest-rate currencies and investing in high-interest-rate currencies. Carry has a long history and, although overshadowed by the trend factor in 2022, has once again become a relevant consideration for investors. After decades of relatively low interest rates, yields have risen unevenly around the globe, from over 15% in Hungary to near-zero in countries like Japan and Taiwan. We see that some emerging market currencies have particularly attractive carry, as central banks there have raised rates to double-digits to fight inflation in advance of their developed market peers.
Meanwhile, recession concerns and slowdown predictions have been mostly U.S.-centric, contrasting with projections for emerging markets, where the expected demand boost from China's reopening expected to support growth in 2023 and 2024, according to the IMF. As a result, currencies of important suppliers to China, such as Chile and Brazil, have started to noticeably appreciate.
Although carry is a strategy that benefits from attractive yields and the low FX volatility that central bank pauses can bring, we should emphasize that it is not a free lunch. Despite low correlations to traditional financial assets, carry's track record shows that it can be vulnerable during systematic tail events, when risk appetite and funding liquidity decrease, such as the 2008 recession, as well as to more idiosyncratic risks like devaluations and geopolitical crises. Thus, gains from carry can quickly erode in implementation as emerging market trading costs rise, making risk management an important consideration.
We advocate mitigating these risks and controlling equity beta through currency selection and using disciplined risk overlays, and we believe that incorporating secondary screens on momentum and capital flows can help control exposure to underperformers. Furthermore, we think that having volatility caps for exposures to individual currencies and strategy-level volatility targeting are additional best practices to keep potential risks in check.
In our view, if the current confluence of conditions persists, global implementations of carry are likely to be well positioned in emerging markets-driven growth upside scenarios. We believe that a thoughtful currency factor mix, risk management, and ongoing monitoring of the broader macro landscape are all important elements in seeking to capture the currency carry upside.
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The Currency Carry Comeback