One behavioural tendency that we frequently discuss is the tendency of investors to lose sight of the long term for fear of short term losses. In the context of foreign exchange markets, this can often cause investors to focus too much on spot price moves and ignore a second element of return that currency investments offer: the yield, or ‘carry’.
Part of the reason why investors may be unwilling to back carry is the manner in which returns tend to be delivered. Returns accrue slowly, and even more painfully, they can periodically be wiped out by rapid, short-term spot rate changes.
The chart below shows the returns on the Deutsche Bank Carry Index, which systematically goes long of the three highest yielding G10 currencies and shorts the three lowest yielding each quarter.
The chart illustrates common characteristics of currency carry strategies. There are multi-year periods earning meaningful returns (7% annualised returns between 1996 and 2007, 5% annualised from 2009 to 2014) before periods of extreme stress. Worse still these periods of drawdown are often correlated with equity market weakness.
However, just as with episodes in other assets, such periods of trauma can offer opportunities for subsequent strong returns and even change the risk profiles of an asset.
Take the Brazilian Real, for example. What was once a shining light of the BRIC nations has been hit by economic mismanagement, high-profile political scandals, and pressure from increasing US rate expectations. This has resulted in significant currency weakness until recently.
At the same time, increasing interest rates have boosted the level of carry on offer, just as other parts of the world have been introducing negative rates to get their currencies to depreciate.
The Brazilian Real going into 2016 therefore displayed the symptoms of a prospective carry trade: recent spot price trauma with elevated carry. And although fundamentals were deteriorating significantly, it was arguably the case that pricing reflected very extreme negative forecasts for the Brazilian economy that left much scope for positive surprise.
The subsequent behaviour of the Real this year has been interesting. The spot price has appreciated even as global equities have been extremely weak. This is in stark contrast to how many would expect emerging market currencies to behave in such periods.
An improvement in oil and metals prices has undoubtedly played a role in this (see figure 4 below), but oil is not the be all and end all and there have been phases of differential behaviour. It is also always worth remembering that carry trades have one favourable characteristic that commodity investments do not have: you earn the yield even if the spot price does not move.
The risk characteristics of some high yielding currencies could also be interesting in the period ahead. Traditionally global growth disappointment is perceived as highly negative for emerging markets. However the environment today is slightly different; if weak growth is associated with low or negative interest rates in the West, then carry becomes a more attractive proposition.
This means that emerging market carry trades could offer diversification versus long equity positions, where traditionally the two have been correlated. It could also explain why even high yielding currencies unrelated to oil, such as the Turkish Lira, have been resilient this year despite weakness in other risk assets and a sharp decline in growth forecasts.
Such trades are always likely to offer a bumpy ride, but the behaviour of emerging market currencies so far this year is another example of the type of themes that we try to emphasise on this blog. It is always important to try to look through the emotional challenge of short term volatility and constant news flow and also to remember that the riskiness of investments can change after behavioural market episodes.
As the chart above shows, the amount of carry on offer for a range of poorly-perceived currencies such as the Real, the Turkish Lira and the South African Rand are elevated relative to their history, while the Russian Ruble is in line, but with an average that is skewed by some very extreme levels.
Such levels of carry offer the potential for both attractive compensation for risk and a diverse source of returns. As such they could offer a real (no pun intended) chance of generating return over the medium-term for investors willing to disregard short-term changes in the spot rate.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.