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Currency Management: Yen and now

Through the 1990s and most of the 2000s the Japanese yen funded a host of the world’s most lucrative carry trades. Daniel Ben-Ami examines whether recent fixes mean that the euro has already shuffled off its role as ‘the yen for the 2010s’

Although many investment professionals might have missed it, the euro carry
 trade, by most accounts, virtually dried up over the summer. As fears about a euro-zone break-up receded, the prospects for a downward drifting euro, a key precondition for the carry trade, appeared to diminish.

This increased optimism about the euro-zone and its currency is apparent in several indicators. The proportion of European fund managers who regarded euro-zone debt funding as their greatest tail risk fell from 48% in August to 33% in September, according to a survey by Bank of America Merrill Lynch. Higher confidence was also reflected in the appreciation of the euro against the dollar from late July.

Having said that, the standard journalistic caveat that these developments were true ‘at the time of writing’ is more pertinent than ever. In recent years the euro-zone has developed the nasty habit of suddenly lurching into crisis after everything appears calm. There is always the chance of another surprise bout of turmoil.

To understand the rise and fall – and possible rise again – of the euro carry trade, it helps to put it into a broader analytical context. Klaus Kusber, a portfolio manager in currencies at Allianz Global Investors in Frankfurt, identifies three broad pre-conditions for a euro carry trade to become worthwhile: the euro must be seen as fundamentally weak or overvalued; central bank rates must be relatively low; and volatility must be low or falling. By examining each of these in turn, it is possible to start to weigh up the prospects for the euro.

It is certainly possible to see a rough inverse correlation between the popularity of the euro carry trade and confidence in the euro-zone. Bad news for the euro-zone is generally, other things being equal, good news for the carry trade. This is what would be expected since the carry trade is, in essence, a bet against the funding currency.

Under such circumstances it should not be a surprise that Humayun Shahryar, the chief executive of the Auvest Capital Management macro hedge fund in Cyprus, says: “We made a lot of money shorting the euro but that was a trade for 2010 and 2011.”

As fears grew over the euro-zone periphery, and even the integrity of the euro-zone itself, the euro seemed to many to be on a clear downward path. Many investors borrowed cheaply in euros and invested in high-yielding currencies such as the Australian dollar or the Brazilian real. Some preferred to invest instead in a basket of such high-yielding currencies. At the time, the euro carry seemed to many a relatively safe and lucrative trade.

There are parallels with the yen carry trade that emerged in the mid-1990s. Back then, Japan’s interest rates were set at near zero as its economy was trapped in a deflationary spiral. It was only towards the end of the last decade, when the financial crisis began to emerge in the West, that the trade started to unwind.

In the euro’s case its problems, if anything, seemed to worsen in late 2011. In September the Swiss central bank introduced a floor on the Swiss franc to limit its appreciation against the euro.

In November and again in December, the European Central Bank (ECB) reduced its key interest rate. By July of this year it had fallen to 0.75% from 1.5% before its November meeting. The tail risk of an exit from the euro-zone, or even the bloc’s complete collapse, seemed to be growing.

It is widely agreed that a combination of political factors helped prompt a euro recovery from late July. On 26 July, ECB president Mario Draghi announced that he would take whatever measures necessary to save the single currency. This was followed in early September by an ECB announcement of the details of its plan for buying the bonds of its troubled member states – outright monetary transactions or OMT.

Another important development was the verdict of Germany’s constitutional court that the European Stability Mechanism (ESM) and the fiscal pact did not violate its constitution. This was seen as welcome news despite caveats such as the need for future ESM deals to receive parliamentary approval and a limit on Germany’s liability.
The Dutch election results in mid-September provided another boost. To the surprise of many, pro-euro centrist parties did well, while support for Geert Wilders’ euro-sceptic Freedom party slumped.

For this new-found optimism about the euro-zone to disappear, and conditions for a carry trade to improve, the situation would need to worsen again. This could come about either as a result of the reversal of recent positive developments or the emergence of new problems.

In relation to recent developments, the unravelling of the ECB’s recently announced plans is perhaps the greatest threat. For instance, Jens Weidmann, the president of Germany’s Bundesbank, has made it clear that he is unhappy about the ECB’s bond-buying scheme. Some commentators have taken his statements to suggest that the German government, wary of a resultant surge in inflation, could harbour reservations about Draghi’s actions.

Sebastian Dullien, a professor of international economics at HTW Berlin, the University of Applied Sciences, does not share this scepticism about Germany’s intentions.
“Draghi would not have done any of these things if there had been serious opposition from the German government,” he suggests. “For [Chancellor Angela] Merkel there is nothing to win if she goes against Draghi. If she stops this programme and the euro crisis deteriorates this will hit the economy as well and will not improve her re-election chances.”

He explains Weidmann’s hostility in reference to the Bundesbank’s narrow institutional interests. As long as the ECB exists, the Bundesbank, once the most powerful central bank in Europe, will have a marginal influence. At present it only represents one out of 23 votes on the ECB’s governing council.

However, Dullien does see the potential for other problems to emerge in the euro-zone, and in particular its banking system. He points out that the details of the euro-zone’s planned banking union are still far from settled. It is not clear exactly how the plan will work, nor which banks will be included. There is also the possibility that after its national elections next autumn the German government could try to push Greece to write-down its debt. “All these small events might be enough to trigger a new panic in the banking system,” he says.

Other experts emphasise different concerns about the outlook for the euro-zone. Malcolm Leigh, a principal in Mercer’s investment business, worries that the ECB might not live up to its promises. “The major risk is that the statement that the ECB made might be stronger than the actions they take,” he says. He also points to the possibility of unrest, particularly in Spain, as a potential danger.

But the prospects for the euro carry trade do not depend solely on developments within Europe. The second factor necessary for the carry trade to take off is that central bank rates are relatively low. Here the word ‘relatively’ is key. By its very nature, the viability of the carry trade clearly depends on what other central banks are doing.

Actions by the US Federal Reserve also played an important part in the recovery of the euro in the late summer. When the minutes of the Fed’s August meeting were released towards the end of that month it started to become clear that a third round of quantitative easing (QE3) was likely. In the event, it was announced at the next Fed meeting in the middle of September.

Allianz’s Kusber says the Fed’s decision played an important part in switching sentiment against the euro carry trade. “People recalibrated their carry portfolios and used the dollar more as a funding vehicle than the euro,” he said.

There is also a good case that there is more uncertainty about the prospects for the US than for the euro-zone. Arnaud Gérard, a senior vice-president at Pareto Investment Management, points out that the effects of QE3 are unknown, elections are imminent and fiscal problems are unresolved. For currency traders it is a question of assessing which is the least bad: “In this game it’s not a race to the most beautiful princess in the club. It’s more a case of who is the ugliest duckling.”

The final factor to consider is volatility. In a climate of low volatility the risks of conducting such a trade are low. But in a highly volatile market there is a chance of sudden and substantial losses.

Stéphane Monier, the deputy chief investment officer at Lombard Odier Investment Managers in Geneva, says. “The Americans say it’s like picking up nickels in front of a steamroller. The carry trade makes a little bit of money every day until you have a big accident.”

Under such circumstances, he argues that it is necessary to have a particularly tight management discipline. Managers should have reasonable expectations about what they can achieve and proper stop losses in place.

Auvest’s Shahryar takes a similar view. In today’s volatile conditions, he says managers should be wary of engaging in such transactions. “It’s a very dangerous trade,” he says. “At some level I think it’s even a foolish trade. The chances of losing money are very high.”

This is not to deny that it might make sense for some funds or companies to hedge against movements in the euro as a defensive strategy. But this is fundamentally different from engaging in the carry trade in a bid to achieve speculative investment gains.

In any event, high volatility looks likely over the coming years. This is partly because monetary easing measures taken by central banks can be seen as a way of pushing down currencies. For example, when the Fed implements QE3, then, everything else being equal, the dollar would be expected to fall. This measure would, in turn, be expected to boost American competitiveness.

The problem is that many central banks are engaged in monetary easing at the same time. In effect, they can be seen as in a competitive battle to push down their own currencies. Auvest’s Shahryar goes so far as to argue that “we are in a currency war out there – although at the moment it’s under the radar”.

It is possible that the euro carry trade will re-emerge but it is likely to need all three conditions to come into place to make it viable: a weakening euro-zone, relatively lower interest rates than elsewhere and low volatility.

In any event, such a trade is always likely to embody significant risks. Even a dramatic tail risk such as a Greek exit form the euro-zone, a development the region’s elites generally oppose, could have unpredictable effects. The event itself would involve high uncertainty but it is possible the euro could strengthen afterwards.
Engaging in carry trades is always likely to require strong nerves.

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