Thomas Stolper Releases Much Anticipated Note

Unfortunately it is not a EURUSD recommendation to be faded and generate 10 out of 10 anti-Stolper track record. However, the Goldman strategist, who has likely taken to following new FX glory boy Alex Hope, takes a look at recent strength (and weakness) in FX carry strategies and finds (rather correctly) that this strength seems driven by little more than a broader rally across risk assets in general. As we have been pointing out, the correlation across our CONTEXT basket (which includes FX carry) has been relatively high both up this year and down very recently, and Stolper discusses whether to fade or follow FX carry strategies and, most importantly, when and why they do and don't work. His unsurprising conclusion being that FX carry can only continue to rise if broad risk assets rise (and vice versa). Somewhat ironically he remains light on tactical recommendations, preferring to watch - nice way to earn a bonus if you can get it.

High Yielders vs Low Yielders FX Carry basket performance...


Global Markets Daily: FX Carry Strategies - Fade or Follow?

  • A sharp pullback across all risky assets yesterday hurt diversified FX carry strategies.
  • We look at a number of variables that have historically been linked to high carry returns.
  • These measures of interest rate variance and correlation with broader risk sentiment...
  • ...all suggest that the fundamental backdrop for carry remains challenging.
  • The recent rally in FX carry since the start of the year, therefore...
  • ...seems to reflect little more than the broader rally across risky assets.

1. Overview

Yesterday, investors continued to worry about Greek PSI participation ahead of the Thursday deadline. With little news from macro data at the same time, equities and other cyclical assets sold off quite sharply over the last 24 hours. European stocks lost about 3% and the SPX closed down about 1.5% at 1343.

We remain light on outstanding tactical recommendations and prefer to observe the developments in Greece as, well as incoming data on the business cycle to assess our next moves. Macro data remains quite strong though positive surprises have become rarer. Moreover, the latest PMI numbers even suggest a very moderate slowing in the pace, as discussed by Stacy Carlson in yesterday’s daily. A positive payrolls surprise on Friday with a benign (orderly) outcome for the Greek PSI could potentially act as catalyst for a renewed strengthening in cyclical assets. Beyond the payrolls data, we will enter the monthly period with second tier macro data releases, which typically provides less of a directional impulse.

In line with the risky asset sell-off, we have seen a small setback in recent days in FX carry strategies, the first more serious one after almost two months of strong performance. In the remainder of this daily we discuss to which extent these positive returns may signal the beginning of a more sustained carry revival, similar to the years leading up to the Global Financial Crisis in 2008.

2. When FX Carry Works

What we call FX carry is also known as the forward rate bias or the violation of uncovered interest rate parity (UIP). All of these ultimately denominate the same phenomenon. On average over long periods of time significant returns could be earned by simply investing in high-yielding currencies, funded out of low yielding ones. In a more technical sense, the high-yielding currencies did not depreciate as much as UIP would have suggested.

Many carry strategies are implemented in more or less sophisticated currency baskets, such as our own investable FX Carry Index, which has recently been revamped to reduce transaction costs.

These FX Carry basket implementations with a bunch of currencies on the long side of the basket and another bunch of currencies on the funding side typically perform well in the following broadly defined situations:

  • when the average interest rate differential between the high-yielding and the low-yielding currencies is relatively high, as this represents the primary source of returns.
  • when the high-yielding currencies appreciate relative to the low-yielding ones (a strong violation of UIP).
  • when the correlation among the basket constituents is relatively low, which helps the diversification of idiosyncratic risks.
  • when the correlation between currency moves and broader risky asset returns are low, as this reduces the likelihood of market-wide risk aversion swings affecting the risk adjusted returns of the strategy.

There is some overlap between these loosely defined conditions but each of them can be traced relatively easily and helps us answer the following question:

3. Is FX Carry Celebrating a Revival?

Since the beginning of the year, FX carry strategies have shown a decent performance. For example, our GS Carry index has posted a return of about 3.5% with a high Sharpe ratio and virtually no pullback. In fact, this has been the best performance window since early 2009, when FX carry strategies rebounded from the 2008 slump.

If we look at our criteria above, in particular the fourth point about correlation to risky assets, we note that the rally in FX carry coincided with a rally in other cyclical assets. And indeed, the weekly return correlation between FX carry and the SPX remains at very high levels of about +60%, which is close to where it has been since the Global Financial Crisis (GFC). As a benchmark, before the Crisis started in 2007, the same correlation typically oscillated around only 20%.

If we look at the correlation of individual currencies with risky assets (as opposed to the correlations of the whole basket), we note that these also remain very strong. We measure this by looking at return correlations between individual trade weighted exchange rates with equity indices. Therefore, diversification benefits still remain a lot more difficult to find than before the GFC, when these correlations were substantially lower in average.

The second issue above is easy to benchmark, because on average over the last couple of years since 2007, the total returns on carry strategies have been almost perfectly flat. Though there have been periods of outperformance, there have been comparable stretches of underperformance. On average the negligible total returns suggest that higher yielding currencies have depreciated sufficiently to erase all positive returns from higher interest rates. On average, one could therefore claim that UIP has not been violated during that period.

Finally, coming back to the very first point made above, the interest rate differential that one can earn remains very low. As a proxy, we calculated the cross sectional standard deviation and the mean across the most important currencies (EM and G10) and found that the average interest rate has not really recovered at all since the crisis and that the cross sectional standard deviation also remains close to the post GFC lows. This means that independent from appreciation/depreciation, the interest rate differentials for diversified carry strategies remain quite low.

Having analyzed all these related indicators, we can only conclude that the recent rally in FX was probably nothing other than a correlated reaction to the improvement in broader risk sentiment. The forward looking implication is that the recent carry rally can only continue if either the broader risk rally continues with little pullback or if the environment for carry becomes more favorable, as discussed above.

Already, the pullback in FX in the first couple of days in March has led to pull-back in total returns of about 0.6% - further evidence of the high correlation with broader risk sentiment.


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