Currency carry trades face trouble

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Currency carry trades face trouble

By Steve Johnson
Published: February 28 2006 18:52 | Last updated: February 28 2006 18:52


The end is nigh for some of the biggest carry trades, spelling trouble for the New Zealand, Australian and US dollars, but benefiting the euro, according to BNP Paribas, the French bank .

A week after a dramatic sell-off in the Icelandic krona heralded a wobble in emerging market and other high-yielding currencies, BNP Paribas is calling a turn in the market for carry trades.

The bank's FX Strategy Carry Indicator has turned negative for the first time since July 2002, except for a one-off dip in January 2005, suggesting that the wall of money that has flooded into carry trades could slow sharply. "We are entering the final stage of the global carry trade. In 2007 we assume it will turn sour," said Hans Redeker, head of currency strategy at the bank.

The bank's indicator compares the average pick-up in carry earned by borrowing in a low-yielding currency and investing in a high-yielding one, with the cost of funding that position in the money markets of the typical funding currency.

BNP Paribas calculates that rising interest rates (and expectations of further rises to come) in funding regions such as Japan, Sweden and the eurozone have pushed up average funding costs to 3 per cent. In contrast, narrowing global interest rate differentials mean the average yield pick-up is just 2.96 per cent.

This means an investor could, in theory, earn more by putting money on deposit than by giving it to a hedge fund to invest in a typical carry trade.

BNP Paribas expects this differential to widen further in the coming year, suggesting conditions for carry trades are likely to deteriorate further.

Some carry trades will still be attractive, but Mr Redeker said that investors would have to become more discerning. He believes the yen-funded Asian carry trade will remain solid, as will flows into Latin America.

However, he sees money being withdrawn from Oceanic currencies, with the New Zealand dollar already 10.5 per cent off its 2005 peak and the Australian dollar about 6.3 per cent lower. Flows into the US are likely to come under pressure next, Mr Redeker said.

Ian Stannard, currency strategist at BNP Paribas, who devised the indicator, believes the euro will switch from being a funding currency to a yielding currency by the middle of this year, as eurozone rates rise.

A similar switch in the US dollar heralded a marked upturn in the greenback's fortunes in 2004, he said.