Euro volatility deals a blow to carry trades

Various denominations of euro banknotes on display at the European Central Bank headquarters in Frankfurt. The financial crisis in Greece has taken away the euro’s appeal as a cheap global borrowing currency, leaving investors with barely any viable and deep markets to finance investments.

Reuters/TokyoThe financial crisis in Greece has taken away the euro’s appeal as a cheap global borrowing currency, leaving investors with barely any viable and deep markets to finance investments. The Japanese yen was historically a popular funding currency for carry trades, in which investors borrow in cheaper markets to invest in higher-yielding assets, but the yen’s recent fickle behaviour has made it less attractive. Expectations of higher US yields also make the dollar a poor funding candidate. Carry trades work best when borrowings are made in a cheap and liquid currency that is either stable or gradually declining. The three most liquid and accessible currencies – the dollar, yen and euro – therefore no longer tick all those boxes, as they used to in the past. Coupled with the uncertainty about emerging market currencies and the decline in global yields, investors reckon carry trades no longer have the same appeal. “There is no easy answer now for which is the right funding currency,” said Mirza Baig, head of Asian rates and currency strategy at BNP Paribas in Singapore. Data from the Commodity Futures Trading Commission showed speculators have trimmed their short euro positions – bets the currency would weaken – for three straight weeks through the latest period ending June 9. That, and the fact the common currency rose even as talks on a deal between Greece and its creditors deadlocked, suggests euro-funded trades were being unwound. The euro has been volatile since cratering at a 12-year-low of $1.0457 on March 16. It bought about $1.14 on Thursday. One-month euro/dollar implied volatility, which measures the cost of hedging against sharp swings in the euro, spiked to a 3-1/2 year high of 14.3% earlier this week. “The very sharp rise in volatility, combined with the fact that the European Central Bank has taken a very hands-off attitude toward this volatility, has made the market doubt whether the euro is the right funding currency,” said Baig. The ECB had not done much to address the rapid rise in European bond yields and that, too, had put pressure on market participants to unload short euro positions, Baig added. Both the Bank of Japan and the ECB are expected to maintain their respective ultra-easy monetary policies, or even ease further, in contrast with expectations that the US Federal Reserve will hike interest rates as early as this year. Long-term bets on the yen’s downside remain largely intact on those divergent monetary policy expectations, even though the Japanese currency has strengthened a little since hitting a 13-year low against the dollar earlier this month. But its recent volatility has made its return as a funding currency unlikely anytime soon. “In the current environment, particularly with the strength of the euro in the face of the possibility of a Greek exit from the euro, there is more hesitation to be short the euro than the yen,” said Bart Wakabayashi, head of forex at State Street Global Markets in Tokyo. After the collapse of Greece’s weekend talks with its lenders, the looming threat of a default or even an eventual Greek exit from the single currency has apparently prompted investors to cut positions that had been profitable this year. For example, according to Thomson Reuters Eikon’s carry trade model, a yen investment in the higher-yielding Indian rupee would have earned more than 5% so far this year through Thursday, with a volatility-adjusted or Sharpe ratio of 3.09, a level that suggests a good return in comparison to risk. In comparison, a euro-funded rupee investment would have returned more than 9%, with a Sharpe ratio of 2.37. The Swiss franc was a good currency to be borrowing until January, when the Swiss National Bank’s abrupt decision to abandon its 1.20 francs per euro cap sent the franc soaring. It has now become a safe-haven destination for investors fleeing the uncertainty of Greece’s ongoing struggle to reach a deal with its lenders and avert default. Few investors however expect markets to return to the heyday of the carry trade, before the 2008 financial crisis. “Carry trades are not as popular anymore,” said Naomi Muguruma, senior market economist at Mitsubishi UFJ Morgan Stanley Securities in Tokyo, partly due to regulatory changes and partly due to falling global yields. “Even if you can get the money cheap, yield curves all over the world have flattened, compared with a year or two ago.”