Rising dollar volatility is endangering a currency-trading strategy that had been a steady winner in recent months.
The carry trade — borrowing where interest rates are low and investing where they are high — is coming under pressure as foreign-exchange swings and expectations for higher Federal Reserve interest rates threaten to overwhelm the yield gains that have driven returns this year. The strategy’s performance stalled in May after strong gains in March and April.
Because the carry strategy is reliant on picking up incremental bits of yield over time, big moves in spot exchange rates can wipe out returns. The trade proved resilient during the opening stages of the Iran War as surging oil prices boosted the appeal of commodity currencies and the dollar remained relatively rangebound.
But now a resurgence of volatility in the greenback, central to much of the world’s foreign-exchange trading, is changing the dynamic.
"Carry has underwhelmed in the past month” as traders bet on a more hawkish Fed, a Barclays Plc team including Andrea Kiguel and Themistoklis Fiotakis wrote on Sunday.
A measure of one-week, implied volatility on the Bloomberg Dollar Spot Index rose Friday to its highest level in a month, as a strong read on US employment stoked bets that Fed officials led by newly installed Chairman Kevin Warsh will raise US borrowing costs by at least a quarter-point come December.
At the beginning of May, swaps traders were pricing in expectations that the Fed would hold rates steady through the end of the year. Now, they’re positioning for more than a quarter-point of rate hikes before next year, matching a hawkish bias reflected in other Group-of-10 peers.
A stronger dollar, meanwhile, would also on its own dent carry strategies that rely on selling the US currency in order to fund positions elsewhere, often in emerging markets.
A sample carry basket funded out of the greenback — long the Brazilian real, Colombian peso and Turkish lira — rose 1.5% in March, 2.8% in April and then was flat in May.
"The stronger US rate/dollar environment is starting to prove a headwind for some of the more popular emerging market plays, including the Brazilian real carry trade,” ING Groep NV currency strategists including Frantisek Taborsky and Francesco Pesole said last week.