Here’s something to add to those lists of 2011 investment themes doing the rounds: whether we’ll get a full-blown comeback of the dollar carry trade in the new year.
Controversial, we know.
But here’s how BNY Mellon’s Michael Woolfolk set the scene on Wednesday, pivoting off the day’s US GDP release:
The final estimate of Q3 GDP came in at an annualized 2.6% from a previous estimate of 2.5%, compared to consensus expectations of 2.8%… The core PCE index eased to an annualized 0.5% in Q3 (previously 0.8%) from 1.0% in Q2 and 1.2% in Q1. This will provide Bernanke with further evidence to justify his renewed commitment to quantitative easing…
With the Dow showing no signs of profit takings going into year end and the European sovereign debt crisis temporarily back on the back burner, growing risk appetite is likely to begin weighing again on the greenback as USD-funded carry comes back into vogue in the new year.
The thing is — the finale of 2010 has been marked by signs of dollar squeezes from an unexpected rally, amid romping FX volatility. And volatility is the kryptonite of carry trades. It’s hard to identify actual laying on of carry trades versus the potential for them, anyway.
Won’t stop us looking, though.
So let’s have a look at an indicator first introduced to us by Sean Corrigan back during that last big carry trade moment in 2009. The chart shows financial commercial paper issued by foreign institutions outstanding in US markets, versus domestic-issued financial CP:
The theory is that foreign-issued financial CP outstanding blew up in 2009 even as domestic financial CP cratered, suggesting a carry trade effect. The pattern did return in 2010′s third quarter (which, the BIS noted in its most recent quarterly report, saw the dollar emerge as a funding currency for carry trades once again). Still, note a last-minute wobble in the amount outstanding.
On the other hand — we bring up foreign financial CP given its known correlation with the Dollar Index:
So — one to watch for 2011.
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Carry-ing on in the eurozone
Of course, we might be looking in the wrong place for the most curious carry movements promised by 2011. Building on its recent tracking of unwinding legacy carry trades funded via the Swiss France during the 2010 eurozone crisis, Goldman observed further on Wednesday:
Long-dated EUR/CHF volatility appears to remain one of the most useful bellwethers of unwinding pressures in legacy CHF carry trades. The reason is that implied EUR/CHF traded at exceptionally low levels during the peak carry period of 2006 and 2007. At the time, implied volatility for 10 year 25 delta EUR/CHF puts was quoted below 3%, well below long dated averages of realized volatility at the time. The aggressive selling of implied volatility at time, i.e. collecting option premium, coincided with a broad preference to also go short low yielding currencies to collect carry.
But now Goldman reckon this unwind has effectively run its course in time for the end of 2010. Well, maybe – Citigroup is now looking to the euro as a funding currency for 2010.
Make it stop.
Related links:
Debunking the size of the carry trade - FT Alphaville (2009)
When quantity may not matter – FT Alphaville
FX still mopping up excess volatility – FT Alphaville
The Fed is the biggest seller of volatility – FT Alphaville