Carry Trade Comeback Could Hurt Euro

Borrow-low, invest-high carry trades in foreign exchange markets are back again after a bad few months, as anticipation of a U.S.-led global recovery lures investors to return to risky emerging currencies, with the euro a likely loser.

In demand are the currencies of the “fragile five” countries highly reliant on foreign capital – the Turkish lira, the South African rand, the Brazilian real, the Indonesian rupiah and the Indian rupee.

All five were shunned for much of last year because of fears the winding down of U.S. monetary stimulus would see funds withdrawn from emerging markets.

But the options market indicates a rally may have legs, as gauges of how choppy the major currencies will be have fallen, encouraging investors to take on more risk in search of returns.

Such risk-seeking trades, in which investors borrow in a low-yielding currency to buy a higher-yielding one, are especially popular among nimble asset managers, speculators and hedge funds.

They have provided steady long-term returns but struggled in the first quarter of this year because of concerns about a sharp economic slowdown in China and a flare-up between Russia and the West over Ukraine, which could undermine a global recovery.

The biggest danger for the carry trade is volatility: the prospect that a sudden fall in the riskier currency will wipe out the profits from investing at a higher interest rate.

But such worries have eased somewhat, allowing investors to focus on monetary policy divergence and macro-economic trends.

While the U.S. Federal Reserve is gradually unwinding its bond-buying stimulus programme and expectations are it may tighten policy in the middle of 2015, the European Central Bank and the Bank of Japan are both pledging to flood markets with cash to support growth and avert the risk from deflation.

via Reuters

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