The trouble with carry

FX traders will find cheap funding hard to exploit

Carry trades should be child's play when so many policy rates are near, or even below, zero. But borrowing low-yielding currencies and buying higher-yielding ones with the proceeds is far from a guaranteed money spinner in current market conditions.

Granted, there are plenty of currencies in which it is cheap to borrow. There are so many that the yen, one of the long-time favourite funding currencies, may drop out of Deutsche Bank's carry funding basket of lowest-yielding G10 currencies for the first time since 1989. Unfortunately, picking a currency to buy with borrowed funds is a trickier matter.

For one thing, the yield pick-up on offer is shrinking fast as one central bank after another eases monetary policy in response to disinflation. True, this is not an insurmountable deterrent to carry trades given investors' desperation for even a small additional return. In a low-yield world, the difference between zero and Australia's policy rate of 2.25 per cent looks pretty hefty.

But the potential returns may not justify the risks. Carry trades work best when exchange rates have a clear trend and volatility is relatively low. In the current market environment, both are absent.

The outlook for several currencies which could be considered as carry trade targets, including the Australian dollar, are tied to swings in commodity prices. With little certainty about how commodity prices will move during the course of the year, leveraged currency bets could go horribly awry. The outlook is no brighter or clearer for many higher-yielding, but riskier and less liquid, emerging market currencies.

Another problem is that volatility has been rising in recent months, not least because of a series of policy shocks. For example, one-month historical euro/dollar volatility has more than doubled since mid-January to 14.3 per cent. The more amplified the currency swings, the greater the risk that leveraged bets could turn sour.

With so many potential pitfalls, ultra-cheap funding is far from guaranteed to spur a boom in carry trades.