Dollar Strength Grows as Carry Trade Profits Shrink (Update1)

Foreign-exchange profits from carry trades are disappearing as differences in central bank interest rates fail to increase fast enough to compensate for swings in currency rates.

Royal Bank of Scotland Plc’s index tracking the strategy of tapping cash where borrowing costs are low and investing where rates are higher, rose 0.57 percent in the first quarter, the smallest amount in a year, and down from 9.8 percent in all of 2009. Morgan Stanley strategists said in an April 15 research report that the only “functionally attractive” currency to target in carry trades is Australia’s dollar.

Falling demand for carry trades may help the dollar -- a favorite for funding the trades because of record low U.S. rates -- extend a rally that drove it 11 percent higher versus the euro the past six months. Gains of almost 30 percent in Brazil’s real, New Zealand’s dollar and South Africa’s rand the past 12 months suggest they already reflect the prospect of higher rates as central bankers begin to shift monetary policy.

“There is no easy money left in the carry trade,” said Henrik Pedersen, the London-based chief investment officer at Pareto Investment Management Ltd., which oversees $45 billion in currency assets.

“Most of the high-yielding currencies are overvalued and the low-yielders are undervalued,” he said. “The gains you can make on the interest-rate differentials are not going to make you 20 percent a year, it’s probably only going to make you about 2 or 3 percent.”

Central Bank Rates

The dollar rose to the highest in almost three weeks versus the yen today after reports last week showed orders for U.S. durable goods excluding transportation items surged 2.8 percent in March and sales of new homes jumped 26.9 percent, the most in five decades. The greenback strengthened 0.2 percent to 94.24 yen and gained 0.1 percent to $1.3370 per euro.

Measured by Bloomberg Correlation-Weighted Currency indexes, the dollar has gained 1.7 percent this year.

A stronger currency is important to the U.S. because it entices foreign investors to Treasury debt that finances the nation’s record budget deficit. The downside is that it may restrain profit growth at companies with international sales by making U.S. exports more expensive.

Euro Predictions

United Technologies Corp., the Hartford-based maker of Pratt & Whitney jet engines and Black Hawk helicopters, and Providence, Rhode Island-based Textron Inc., which produces Cessna planes, predicted the euro would trade at $1.41 or higher this year.

“The global convergence in yields has basically sidelined the demand for carry,” said Mike Moran, a New York-based senior currency strategist at Standard Chartered Plc. “What has happened over the last 18 months has really leveled the playing field in carry trades. It has driven a convergence in the two most important factors in the carry trade, yields and volatility.”

Carry trades, which flourish most when interest-rate spreads are wide and swings in exchange rates muted, lost 31.5 percent in 2008 as the global financial crisis led to a compression of central bank borrowing costs, before rebounding last year, RBS index data shows.

Coordinated Effort

The Federal Reserve, European Central Bank and four other central banks lowered rates in October 2008 in an unprecedented coordinated effort to ease the effects of the worst financial crisis since the Great Depression.

Central bankers are now preparing rate increases as the global economy recovers. The Reserve Bank of Australia boosted its overnight cash rate to 4.25 percent this month from 3 percent in October. New Zealand’s benchmark rate is 2.5 percent, compared with 0.1 percent in Japan and a range of zero to 0.25 percent in the U.S.

In January 2007, rates were 0.25 percent in Japan, 5.25 percent in the U.S., 6.25 percent in Australia and 7.25 percent in New Zealand.

Investors who took advantage of global rate differentials averaged annual returns of 16 percent from 2000 to 2005, according to the RBS index. The best gains of the decade were in 2002, when the strategy returned 29.3 percent.

At 10.1 percent, three-month implied option volatility for emerging economies is about one percentage point less than for currencies of major industrialized nations, a JPMorgan Chase & Co. index show. In October 2008, emerging volatility was 13 percentage points more.

‘Not Very Attractive’

Higher volatility reduces the allure of carry trades by increasing the probability that swings in exchange rates will erode gains. The JPMorgan option index measuring swings in industrialized nation currencies averaged 7.7 percent in the two years before the subprime-mortgage market collapsed in August 2007.

“The carry trade is not very attractive now, broadly speaking,” said Ronald Leven, a senior currency strategist at Morgan Stanley in New York. “There also is some shifting away from the dollar as a funding currency.”

Leven forecasts the dollar will appreciate to 109 yen and $1.24 per euro by December. Federal fund futures traded on CME Group Inc.’s Chicago Mercantile Exchange show traders place a 56 percent chance the U.S. central bank will lift its target for overnight loans between banks by November.

Greece, Portugal

The dollar has benefitted at the expense of the euro, which has been plagued by concern about the ability of Greece and other European countries such as Portugal and Spain to meet their debt obligations.

Greece asked the European Union and International Monetary Fund on April 23 to activate a lifeline of as much as 45 billion euros ($60.2 billion) in an unprecedented test of the euro’s stability and European political cohesion.

“The alleviating of financing stress in Europe should reduce the risk aversion bid for the dollar that emerged last December and lead markets to return to dollar funding of carry and risk trades,” strategists at Zurich-based Credit Suisse Group AG wrote in an April 13 report.

The company forecast the dollar will weaken to $1.43 per euro and to 92 yen in three months.

The Aussie gained 28 percent against the U.S. dollar and 24 percent versus the Japanese yen in the past 12 months as the RBA began raising rates in October.

Bank of Canada

The Bank of Canada signaled last week it may be the first Group of Seven nation to boost borrowing costs. India raised rates for the second time in a month last week and Sweden’s Riksbank reiterated a forecast to boost its seven-day repurchase rate by the end of the third quarter.

“Regardless of when exactly the Fed raises rates, there is already a waterfall going on in movements of U.S. rates above those in other nations,” said Marc Chandler, head of currency strategy at Brown Brothers Harriman & Co. in New York. Investors “have been paid for being short the U.S. dollar, but that incentive structure is changing,” he said.

The cost of borrowing in yen for three months between banks fell below the dollar rate on March 4 for the first time since August, lessening the appeal of the greenback as a funding currency.

The London interbank offered rate, or Libor, for three- month yen loans was 8.375 basis points less than the dollar rate last week, the most since July. The dollar rate moved below its yen counterpart last year for the first time.

“Ten years ago it was basically the carry trade as a free lunch,” said Maxime Tessier, chief of foreign exchange at Montreal-based Caisse de Depot et Placement du Quebec, Canada’s biggest pension fund manager, with $131.6 billion in assets. “If we are in an environment where risk appetite remains subdued, and questions remain about what will happen with economies and central banks going forward, and if the fiscal crisis we are now seeing will broaden, then this is not the ideal environment for carry.”