Carry makes a comeback
Rapid tightening cycles, combined with increasing policy divergence from global central banks may mark the beginning of a new era for once popular investment strategies such as FX carry. The strategy had fallen out of favour as low/negative interest rates and quantitative easing compressed interest rate differentials globally. However, we sense that might now be changing.
For example, the chart below shows the average monthly FX carry across 36 G10 crosses over time . Carry was higher prior to 2009, the turning point being, of course, the financial crisis and subsequent period of extraordinarily accommodative monetary policy in G10 economies. Recent central bank actions have, however, led to a rapid increase in ex-ante carry, now back to levels not seen since prior to the collapse of Lehman.
Figure 1: Average monthly carry across 36 G10 FX crosses
Higher ex-ante carry isn’t, on its own, compelling evidence that FX carry strategies will be better investments now than they were, say, 2 years ago. However, we think it is a decent starting point. Simplistically, we also observe that prior to Lehman, a very simple FX carry strategy (shown below) performed quite well, whereas post-Lehman it did not. This coincides with the periods of higher / lower ex-ante carry in the chart above. With carry now back at similar levels to those that prevailed pre-Lehman, we believe the chances are decent that FX carry will make a comeback.
Figure 2: Historical performance of a simple hypothetical G10 FX carry strategy
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1 We measure ex-ante FX carry as the implied return from entering a 1mth FX forward and unwinding the position at the current spot FX rate.
2 The carry strategy shown goes long the top 4 yielding currencies and goes short the bottom 4 yielding currencies each month. The strategy earns the interest differential between the currencies plus any movement in the spot FX rates.
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