Recovery In Carry Trades Looks Unlikely Now

The unwinding of carry trades may well have passed the point of no return.

Until now, the sale of high yielding currencies in favor of lower-yielding ones were all part of the rise in risk aversion as subprime mortgage concerns swept across global financial markets. Any recovery in risk aversion was expected to bring a rebound in carry trades as investors resumed one of their favorite trades of the last year or two. However, currency strategists aren't so sure this will happen now. With carry trades now falling back below levels recorded during the last reversal in March this year, and with Japanese retail investors now showing a reluctance to sell the yen - a key low yielder - chances are that the unwinding of carry will continue. "Judging by credit volatility...and the widespread contagion from U.S. credit across asset classes and geographic regions we aren't at the bottom of the 'carry' cycle yet," said Lena Komileva, Group of Seven leading industrial nations economist with international brokers Tullett Prebon in London. Even those who are still looking for a recovery doubt that the carry trade will return as it was before. "At some stage, investors will bargain hunt again in global markets and the carry trade will resume, albeit perhaps with less fervor," said Callum Henderson, head of currency strategy at Standard Chartered Bank in Singapore. Adrian Schmidt, senior foreign exchange strategist with The Royal Bank of Scotland, reckons that the current jitters in financial markets could prevail for the rest of the summer and that it may take "a month or two of solid data and evidence that there is no lasting damage to any major financial institutions." Thus, he suggests, "yen strength still has some potential to extend." "Even though a lot of short term short yen positions have probably been squared, the major trend has yet to be broken and longer term positions in euro/yen could still come under pressure," Schmidt argued. Others suggest that the unwinding of carry has attained a certain level of momentum. Adam Cole, senior currency strategist with RBC Capital Markets notes that the Australian and New Zealand dollars have both fallen to their lowest level against the yen since "the last bout of credit market jitters," in March. Tullet Prebon's Komileva also noted that carry trades have breached these earlier lows, but noted that the downturn this time round has taken nearly double the length of time. This could be due, at least in part, to the continued interest Japanese retail investors have shown in foreign asset purchases even while carry was unwinding. Derek Halpenny, senior currency economist at Bank of Tokyo-Mitsubishi in London, noted that this made the margin trading sector in Japan act as a "shock-absorber," buying the high yielders on dips. But, Halpenny reckons that the reversal in carry has now probably gone too far for the margin players to maintain this strategy. "Data from the Tokyo Financial Exchange suggest a change is already occurring," he reported, noting that net long euro/yen and New Zealand dollar/yen positions were cut on several recent occasions when these pairs declined. "The evidence of margin traders buying on dips is diminishing, which is hardly surprising given current market conditions," Halpenny said. "Fear and panic could prompt further position liquidation," he added.

Carry Trades May Still Return

Nevertheless, there are still those who feel that carry will return. Robert Sinche, head of global foreign exchange strategy with Bank of America in New York, suggests that as long as core global liquidity levels aren't compromised and that global growth conditions haven't been hurt, there should be some reversal as risk aversion subsides. "In this environment, a number of recent foreign exchange rate shifts appear out of line with likely fundamental influences during the weeks ahead," Sinche said, noting that selling of the Australian and New Zealand dollar appears "excessive" given underlying interest rate and terms-of-trade fundamentals and that a recovery in the euro against the yen should be expected as the European Central Bank is still likely to tighten rates before the Bank of Japan. Early Thursday in Europe, as global equity markets continued to head lower, carry trades continued to unwind fairly violently with the dollar tumbling to Y115.92 by 0645 GMT from Y116.72 late Wednesday in New York. The euro was down at Y155.62 from Y157.00 while the single currency also down at $1.3425 from $1.3452.