CARRY TRADES ARE AT RISK AGAIN IN 2010 / THE FINANCIAL TIMES ( HIGHLY RECOMMENDED READING )

Carry trades are at risk again in 2010

By Mansoor Mohi-uddin

Published: January 27 2010 14:39

2010 will be a very different year to 2009. Last year foreign exchange players were rewarded by returning to carry trades in emerging markets and commodity currencies.

By ignoring the weak global economic outlook, risk-seeking investors shunned the safe-haven US dollar and Japanese yen, and instead placed their bets on higher yielding currencies.

Those bets paid off in 2009. The euro rallied from $1.25 to $1.50 against the dollar. The Australian dollar rose from sixty to ninety cents versus the greenback. But in 2010 carry trades are at risk again. Investors shouldn’t assume last year’s liquidity fuelled rallies will continue. They need to focus once more on fundamentals.

But, what are those fundamentals?

First, valuations matter. Currencies may diverge from their long run equilibrium values for years. During the credit bubble of 2003-2007 – and even well into the credit crunch – the dollar and yen continued to fall against the higher yielding euro. By the summer of 2008, the single currency was worth $1.60 and Y170 respectively. But when investors turned extremely risk averse after Lehman’s demise, the reversal in foreign exchange markets was savage. The euro plunged to $1.23 and Y117. Thus, by the end of 2008, equilibrium values had been brutally restored. Investors shouldn’t be surprised by exchange rates behaving similarly in 2010.

Second, carry trades did so well last year because monetary and fiscal policies were loosened by extraordinary degrees around the globe. But in 2010 fears of record budget deficits, debt defaults and inflation are prompting officials to start reining in super-loose economic policies.

Already the Reserve Bank of Australia and Norges Bank have started raising interest rates. In addition, China’s authorities have begun increasing banks’ required reserve ratios. In 2010 UBS economists expect all the world’s major central banks – barring Japan - to raise interest rates.

At the same time fiscal policies are being tightened globally. In the major economies, the Massachusetts’ Senate result and the politics of this year’s general election in Britain reflect voters demands for politicians to shore up public finances. Conversely, in smaller economies like Greece, Ireland, Portugal and Dubai, financial markets are forcing governments to adjust spending rapidly.

Third, exchange rates have become misaligned and carry trades crowded even though the global economy remains fragile. Higher interest rates and tighter fiscal policy are only one risk to the outlook. Other sources of uncertainty are high levels of unemployment leading to social unrest in Europe, the Obama administration’s new proposals on banking regulation in America, and the recent deterioration in relations between the United States and China. The challenges that financial and currency markets face in 2010 are growing not receding.

As a result investors should be wary of carry trades unwinding sharply this year, and policymakers need to stand ready to intervene in the foreign exchange markets.

The behaviour of the Swiss franc illustrates these risks. After the credit crunch began in 2007, the franc rallied from 1.68 against the euro to a high of 1.44 as investors unwound carry trades funded in Switzerland’s currency. This prompted the Swiss National Bank last year to intervene unilaterally for the first time in almost two decades to curb the strength of the franc, and prevent Switzerland’s economy from tipping into entrenched deflation.

But despite the central bank selling enough domestic currency to double its foreign exchange reserves in 2009, the franc has strengthened sharply again this year as demand for safe-haven currencies has increased further. This has prompted renewed threats of intervention by the Swiss National Bank to curb the rise of its currency.

What is occurring now in the Swiss franc market is likely to be repeated in the rest of the major currency markets in 2010 as investors re-assess the value of carry trades. Already the dollar and yen have begun this year to regain lost ground against the euro and commodity currencies. The single currency has fallen from $1.50 to $1.40 against the greenback in just over a month.

But as 2008 showed exchange rates can move far more drastically when investors unwind carry trades en masse. The risk of foreign exchange volatility must be a priority for discussion when the G7 finance ministers meet this weekend in Canada. At a minimum they should discuss the possibility of Tokyo entering the currency markets for the first time since 2004 if increased risk aversion suddenly forces the yen higher. More substantially the ministers should also consider co-ordinated intervention if exchange rate volatility spills over into global asset markets this year.

Mansoor Mohi-uddin is managing director of foreign exchange strategy at UBS

Copyright The Financial Times Limited 2010.