Why The Unwind Of The Carry Trade Is Increasing Volatility
Central bank interest rates are of fundamental importance to exchange rates and foreign exchange flows as they determine the direction and profitability of carry trades. When the interest rate differential between two central banks is positive, it is generally possible to borrow a currency at a low-interest rate, exchange it for another currency and then lend the resulting currency at a higher rate to obtain a premium. Although an exchange rate risk does exist in this trade, currency markets often move in the direction of the higher interest rate currency, further increasing the profitability of the position. Because of the small magnitude of movements in currencies, these trades are commonly highly levered.
Throw in a lot of leverage, some gasoline, an economic shock, and things get interesting. During crisis periods, central banks will tend to reduce their interest rates in unison, compressing carry trade differentials and causing an unwind of carry trade positions. The more leverage, the faster the unwind. In 2008, this happened in the Japanese Yen crosses, where trades that had been profitable for decades unwound precipitously, substantially dropping the exchange rate of most currencies against the Yen.
Since the Great Recession, interest rates never recovered to their 2007 highs, causing most carry trade differentials to be significantly smaller. The direction of carry trades in the highest yielding pairs like AUD/JPY and NZD/JPY remained the same – with AUD and NZD being highly yielding currencies and JPY being very low cost to borrow. The EUR/USD carry trade, did reverse, with the lending of USD being profitable after borrowing EUR, a phenomenon that did not happen in the Great Recession. The image above shows the difference between 1-year swap rates of major central banks against the Fed’s 1-year swap rate. You can see that the only two currencies you could borrow and then exchange for USD and lend at a profit would be the EUR and the JPY, with the EUR being the only one with high enough profitability (with a differential of around 200 basis points in February).
In the images above, you can see that this swap rate differential started to become less favorable with the imminent lowering of Fed interest rates. There was then an immediate depreciation of the US dollar, which was most likely caused by the unwinding of relatively large positions in the EUR/USD trade. This unwind had a positive effect on dollar liquidity, because it meant selling US dollars to buy Euros. This time was also associated with a rally in the US treasury market that lasted exactly up until March 10th, when the dollar index slide stopped.
The dollar index then moved aggressively in the other direction as market participants simultaneously scrambled for dollar liquidity. This liquidity crunch caused a dramatic collapse across most market sectors and spiked volatility to levels not seen since the Great Recession. In need of liquidity, investors sold US treasuries with both hands and both feet causing a dramatic selloff in this safe-haven asset to cover margin calls elsewhere.
As discussed in an earlier letter, US treasuries were already under significant stress caused by the decoupling between on and off the run treasury yields. This disconnect forced the unwinding of the levered basis trade, causing even more selling pressure on US Treasuries. The combined effect of this selling pressure increased the intraday volatility of US Treasuries to over seven standard deviations above its mean or four standard deviations higher than 2008. This prompted the Fed to start a massive US treasury buying program to restore the functionality of pricing in the US treasury market.
In 2008, the unwinding of the carry trade took longer than one week. The most levered participants are the first to unwind their positions, but as the trade continues to work against investors, additional positions are eventually liquidated. Be on the lookout for short-term moves up in the EUR/USD and moves lower in the dollar index.
Whether these moves are strong enough to lead to a continuous decline of the dollar index itself is unlikely mainly for two reasons. First, lower commodity prices are generally bullish for the US dollar, as they imply lower demand of dollars from commodity producers. Second, many other carry trades have the USD as the borrowed currency (AUD/USD, NZD/USD, etc), which are likely to unwind in the opposite direction. This puts upside pressure on the dollar index. Currently, most levered positions have been liquidated, so we are likely to see a bullish trend in favor of the US dollar. This might be exacerbated by US companies and investors seeking to sell less liquid ex-US assets to bring money to the US to support their businesses during these challenging times.
In summary, the dollar is likely to appreciate through this crisis period, as it has done through previous economic cycles. However, the existence of the now important EUR/USD carry trade against the USD is likely to diminish the overall magnitude of this move. The upward trend in the dollar index is supported by low commodity prices, so watch for increases in the prices of commodities – especially oil and copper – which could signal a reversal of this trend.
The Fed’s credit facilities have compressed volatility to more manageable levels. There is almost certainly more 5% moves in front of us, but these moves should be caused more by economic news than a lack of liquidity. Good trading in these challenging markets.