Bilal’s Macroscope: Forget Equities, FX Carry Is King of 2023 (But Not for Long)

Summary

• FX carry has outperformed equities, bonds and commodities in 2023 on a Sharpe ratio basis.
• But returns are near cyclical highs, correlations are off, and August is typically bad for carry.
• We would therefore be cautious on carry from here.

The Year of FX Carry

17%. That is how much a global basket of FX carry trades has delivered in 2023 so far. And that is way higher than bonds at 3% and commodities (down 5%). Only global equities have delivered similar returns at 18% (Chart 1). However, when adjusted for volatility, FX carry has delivered a Sharpe ratio of 3.4 this year compared with the 2.3 of equities (Chart 2). No matter how you slice and dice it – this has been the year of FX carry.

There are different flavours of FX carry. Our base portfolio consists of buying the five highest-yielding currencies and selling the three lowest-yielding ones. Currently, that would entail buying TRY, COP, HUF, MXN and BRL and selling JPY, CHF, TWD, CNH and MYR. This is the basket that has delivered a total return of 17%. Other flavours include adjusting the yield with FX volatility then ranking the currencies, and conditioning the yields on equity performances. We track them all in our weekly FX Carry Report.

The big question is whether these stellar returns can continue. We have our concerns for four reasons.

1. FX carry returns are near cyclical highs. We know FX carry makes money most of the time, but then blows up. In some ways, the large drawdowns are the risk for which investors are being compensated. This leads to a cycle of carry returns. Currently, the rolling 12-month excess returns are at 21% – near the typical highs (Chart 3). If it ekes out another 5%, it would reach a two standard deviation extreme. This suggests we could be near the final run of positive returns, so we need to wary of flat returns or, worse still, a drawdown.
   
2. Risk appetite cannot improve. Our market risk monitor, which aggregates risk measures across multiple markets, is comfortably in ‘risk-seeking’ territory. Everything is therefore looking benign, but we know such states do not last forever (Chart 4). By definition, market risk measures cannot stay in their low extremes forever. We would watch credit spreads, which are at extreme lows (Chart 5).
   
3. Correlations are off. Normally, global FX carry has strong correlations with US stocks, US yields and G10 FX carry, but today that is not the case. The strongest (non-FX) correlations are with Italian bond spreads, wheat and China 2y yields (Table 1). This could suggest investors not typically trading FX carry have entered the market, which could be a harbinger of bad things.
   
4. Seasonality is negative. If there is one month that FX carry does not perform, it is August (Chart 6). On average, returns underperform by over 1%, and they are negative 65% of the time. Of course, seasonality could be spurious. One potential rationale for weak performance in August is poor market liquidity. Bank traders disappear on holiday, so juniors are manning the desks, which leads to poor liquidity and gap moves. The last two years have been fine for FX carry in August, but the previous three were poor – so perhaps we are due for a bad month again.

On balance, the clouds are starting to gather for carry underperformance. We would be cautious in August and keep an eye on credit spreads for the timing.

Our Current Discretionary Trades

Our portfolio has returned +7.1% YTD, down slightly from last week, and +48.8% since inception (+12.2% annualised) with a 1.2 Sharpe ratio. This continues to place it above the average discretionary macro hedge fund (Bloomberg: BHDMAC Index; Chart 1). Our largest risk positions (VaR) are in FX, followed by rates, and then equities. Our current positions are as follows:

DM

1. Long 10Y Bonos vs 10Y OAT (target 40bp) – read here.
2. Short 1Yx1Y US OIS vs 1Yx1Y SONIA (target 100bp) – read here.

3. Short UK 10Y Inflation Swap (target 3.65%; stop 4.0%) – read here.
4. Pay 6M forward 1Y EUR OIS (target: 4.0%) – read here.
5. Long EUR/GBP (target: 0.89; stop loss: 0.845) – read here.
6. Short 10Y Treasury vs. 10Y Bunds – read here.
7. Long 1yx1y receiver swaption with a 1yx1y pay fixed swap positions – read here.

EM

1. Long SHCOMP (target: 3,600) – read here.
2. EM to rally – read here.
   • Short USD/IDR 3M NDF (target: 14,000).
   • Short EUR/CZK (target: 23.25).
3. Receive 2Y INR OIS (target: 6.0%) – read here.
4. Short SGD/THB into Thai elections (target: 24.75) – read here.

Bilal Hafeez is the CEO and Editor of Macro Hive. He spent over twenty years doing research at big banks – JPMorgan, Deutsche Bank, and Nomura, where he had various “Global Head” roles and did FX, rates and cross-markets research.

Photo Credit: depositphotos.com

(The commentary contained in the above article does not constitute an offer or a solicitation, or a recommendation to implement or liquidate an investment or to carry out any other transaction. It should not be used as a basis for any investment decision or other decision. Any investment decision should be based on appropriate professional advice specific to your needs.)