If you looked only at the dollar and FX volatility, 2019 may have seemed a dull year. The dollar is up, but it’s been a choppy and modest ascent. But this narrow view would miss the anything but dull performance of one particular type of FX investment strategy: the carry trade. This year, it has delivered stellar returns. A basket of global FX carry trades has delivered returns of close to 15%…
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If you looked only at the dollar and FX volatility, 2019 may have seemed a dull year. The dollar is up, but it’s been a choppy and modest ascent. But this narrow view would miss the anything but dull performance of one particular type of FX investment strategy: the carry trade. This year, it has delivered stellar returns. A basket of global FX carry trades has delivered returns of close to 15%.
The strategy involves borrowing in low interest rate currencies and investing in high interest rate currencies. And it has been part of the toolkit for FX investors for decades. At the moment, a simple basket could consist of being long TRY, ZAR, MXN, RUB, and IDR; and short CHF, TWD, EUR, JPY, and SEK.
Last year, the strategy made 5% and the year before it was flat – so it was due a good year (Chart 1). It helped that many high interest rate, emerging market currencies suffered large selloffs in 2018, so their valuations coming into this year were attractive. It further helped that the major central banks like the Fed and ECB all became dovish, too. Nothing boosts the search for yield like core central banks offering meagre yields.
The trouble is that the returns may be too good. The rolling 12-month Sharpe ratio (the excess return divided by volatility) is currently over 2.0 and it was over 3.0 just a few months ago (Chart 2). In the long run, carry trades tend to deliver Sharpe ratios close to the 0.5 to 1.0 range. So the recent decline in the Sharpe ratio could be a reversion to the mean. This may mean that investors will need to be more selective in their choice of carry trades. Importantly, this suggests we should be cautious in expecting such high returns in 2020.
Chart 1: Global FX Carry Basket*, Annual Returns
Source: Macro Hive, Reuters
Chart 2: Global FX Carry Basket*, Rolling 12m Sharpe Ratio
Source: Macro Hive, Reuters
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.