Bilal’s Macroscope: The ‘Risk-On’ Trade Everyone Is Ignoring

Markets are bipolar. US equity markets rallied 5% from their Thursday lows suggesting that the equity market may be bottoming. Yet, UK pension fund LDI risks are giving signals of significant fixed income risks. In some ways, this sums up the year – periods of hope punctuated with bouts of market turmoil. Through all of this, US equities are down over 20% this year, US 10-year yields have risen 2.4% while US high yield spreads have widened 200bps. Asset returns have been similarly poor for the rest of the world. But one ‘risk-on’ strategy has thrived – the FX carry trade. Our carry portfolios are up between 10% to 28% this year.

FX carry trades are the closest FX markets get to delivering a risk premium. You borrow at a low-interest rate in one country and invest in a high-interest rate in another country. The difference in interest rates – the carry – is the net interest you are ‘assured’. The hope is that the currency does not move against you and wipe out the carry gains. Studies have found that, over time, FX carry trades do deliver positive excess returns. This means that spot moves tend not to move by enough to wipe out the carry gains (the so-called forward rate bias).

FX carry had done well for decades until the Global Financial Crisis (GFC) hit. This led to an infamous carry unwind, but it also led to interest rates around the world falling. The median interest rate, across G10 and EM markets in the 2000s, was around 5% but after the GFC it fell to 2%. This coincided with paltry carry returns. Now, with central banks hiking rates, we are back to median rates of 5%. The scope to engage in FX carry trades has therefore become more attractive and this year’s stellar returns have shown that.

However, investors are yet to embrace the FX carry trade. Our positioning metrics suggest hedge funds are long USD against both low-yielding G10 FX, such as  JPY, and high-yielding G10 FX, such as CAD. Meanwhile, real money investors are long low-yielding FX, such as EUR. Then, turning to Japanese investors, they are short USD/JPY despite a negative carry. All of this suggests that outright carry strategies are yet to enter the thinking of most investors.

So, how do you play carry? Our approach is to use baskets of carry trades. We have created four flavours:

1. Simple yield (Classic Carry) – we rank currencies by their short-term yield, then buy the five highest yielders and sell the five lowest yielders.
2. Carry adjusted for FX volatility (Carry:vol) – we rank currencies by their short-term yield, adjusted for volatility, then buy the five highest yielders and sell the five lowest yielders.
3. Carry conditioned on equity performance (Carry:equity)– we start with the Classic Carry portfolio in (1) and then knock out high-yielders with relatively poor equity performance and low-yielders with good performance.
4. US Dollar carry trade (G10/USD Carry) – we buy USD if USD yields are higher than the average of the rest of G10, otherwise, you sell.

This year, portfolios (2) and (4) have performed extremely well –carry:vol is up 28% while G10/USD Carry is up 19%. For reference, carry:vol is long currencies like INR, MXN, and BRL, and short currencies like JPY, CHF, and EUR. While the recent carry returns may not extend at the same pace, the upshot is that with the return of higher interest rates across the world, the FX carry trade is back.

Our Current Favourite Discretionary Trades

In general, we are bullish USD, bearish rates and equities. More specifically, we like to be:

1. Long USD: short EUR/USD, long USD/INR
2. Short rates: short bunds, paid PLN, CZK, INR 1Y or 2Y rates
3. EM FX crosses: long SGD/CNH, long THB/TWD and short ZAR/IDR

We are also considering short NOK/SEK and short AUD/JPY. We are holding back from an equity trade for now, given the recent volatility.

Do Our Models Agree with Us?

As usual, I like to cross-check our views against our models:

• Our momentum models are giving uniformly bullish USD signals. These models have performed well, as of late. The models are also giving bearish signals on rates and equities. Both support our discretionary view.
• Our positioning data shows that hedge funds have reduced their EUR and JPY shorts, and increased their GBP longs, while real money continues to be long EUR and short GBP. Hedge funds are short rates and equities, while real money are long rates and moderately long equities
• Our flight data shows flights out of Chinese airports have plunged, which is a bearish signal for the economy.

We have updated our Bank of England Hawkometer. Mann, Haskel, and Ramsden are the hawks while Dhingra and Tenreyro are the doves.

Recent Questions from Clients

• Is there any way out for the UK?
• Are UK pension funds close to bankruptcy?
• Why is GBP holding up?
• Why did equities rally on Thursday?
• Why do US inflation forecasts keep underestimating inflation?
• Could China’s Party Congress produce big fiscal stimulus or the end of zero-COVID?

What I’m Reading and Watching

• Here are five striking short videos I recently came across.
• I gave up reading Robert Harris’ ‘Act of Oblivion’ but started his earlier book ‘An Officer and a Spy’, which is much better.
• I recently watched the Tom Ford 2016 film ‘Nocturnal Animals’. It was very good.
• The Surprising Ages of the Founding Fathers, Alexander Hamilton was 21. What was I doing at that age?!
• Scientists Apparently Taught Brain Cells How to Play Pong. Brain cells may then be used in machines.

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.

(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.)