Historically low interest rates in the United States are, as we know, supposedly encouraging investors to put on dollar-funded carry positions.
But while current interest-rate differentials might imply this is a very profitable and popular trade, Barclays Capital warned clients on Thursday it would be a mistake to assume it’s quite as common as some believe.
According to the BarCap analysts, it all comes down to volatility-adjusted spreads – i.e. the risk of exchange rates moving against you.
As they noted (our emphasis):
The size of carry traders is notoriously difficult to measure, and there is considerable speculation on their size based on very incomplete evidence. Consider, however, a measure of the classic incentive to put on carry trades — volatility-adjusted spreads. We use two such measures, the volatility-adjusted spread between AUD and JPY and the volatility-adjusted spread between AUD and USD. In each case, we divide the 10y yield differential between by one year implied volatility.
These measures do not encourage the view that carry trades would be put on in size . Whatever the incentives from the rate differentials, implied volatilities remain high enough to discourage carry trades. In both cases, the incentives are not only well below the peak, they are well below the average.
If anything, this suggests that the market may be overestimating the extent of carry trades now in place and underestimating the potential for carry trades to be instituted if implied volatilities pull closer toward historical norms and realized volatility.
In other words, it’s only when volatility diminishes that we will really begin to see the instigation of the “mother of all carry trades“. Be warned.