TLT•Swiss franc short positions approaching extreme levels - JPM
Canadian dollar implied volatility historically low
Real central bank policy rates
(By Jamie McGeever, Editing by Marguerita Choy)
(jamie.mcgeever@thomsonreuters.com; Reuters Messaging: jamie.mcgeever.reuters.com@reuters.net/)
Before the U.S. and Israel attacked Iran at the end of February, the dollar .DXY was shaping up to be an alternative. It was languishing at a four-year low against a basket of major currencies, and markets were pricing in two or maybe three rate cuts from the Federal Reserve by year-end. Talk of "de-dollarisation" was still in the air. That seems like a long time ago.
Now the Fed and many other G10 central banks are beginning, or have already begun, to raise interest rates in an effort to combat bubbling price pressures.
In this environment, picking the currency to sell in a carry trade is becoming quite tricky.
SWISSIE OR LOONIE?
The obvious candidate is the Swiss franc CHF=. The Swiss National Bank's policy rate has been anchored at zero for more than a year, and rates traders are pricing in barely 50 bps of tightening by the end of 2027. The real policy rate is close to -1% and the inflation-adjusted 10-year bond yield is also below zero, the only negative 10-year real yield across the G10 group of nations.
As JPMorgan's FX strategy team notes, shorting the Swiss franc offers "the cleanest exposure" to accelerating global growth via a currency that is "largely untroubled by (the) policy/intervention noise plaguing the yen."
But this is already becoming a crowded trade. Using a composite of Swiss franc positions against the dollar and euro across futures and options markets, JPM estimates that bets against the franc are approaching the "carry-mania extremes" of 2024.
Meanwhile, speculators are also betting quite heavily against the other obvious funding currency, the Canadian dollar CAD=. Funds hold a nearly $8 billion bet against the "loonie," down from nearly $13 billion earlier this summer, according to Commodity Futures Trading Commission (CFTC) positioning data, and one can see why.
The Bank of Canada has held its policy rate at 2.25% for nearly a year. Canadian dollar implied volatility is also particularly low, a strong advantage for carry trades, as high and sudden bursts of volatility can quickly wipe out a carry trade's interest-rate-derived gains.
The widely held market assumption has been that the BoC would resume raising rates by the end of this year. But the sudden explosion of the trade war with the U.S. has thrown a huge cloak of uncertainty over the country’s economic outlook.
There are two plausible scenarios that could play out in the coming months. Exports bound for the U.S. slump, growth suffers, and the BoC is less inclined to raise rates. This would likely weaken the Canadian dollar.
Alternatively, the weak exchange rate and Canada's counter-tariffs on U.S. goods raise price pressures for Canadian consumers, forcing the BoC to deliver more hawkish rhetoric on inflation, if not direct action. In turn, the current Canadian dollar and rate-hike expectations could hold up.
If it's the former, the "loonie" will become a more attractive funding currency as near-term expectations around BoC rate hikes recede. If it’s the latter, not so much.
LIQUIDITY
One potential hurdle to being a carry trade funding currency is liquidity. The yen is the third-most-traded currency in the world. Swiss franc and Canadian dollar volumes are only around a third of the yen's footprint, making sudden market turns potentially very painful.
If low volatility, low nominal and real interest rates, and deep liquidity are key elements of funding carry trades, another potential candidate jumps out: the euro EUR=.
But the European Central Bank is emerging as a notable rate hiker. It is almost certain to raise rates 25 basis points on Thursday, and by a further 50 bps by April, according to rates futures markets.
Shorting the world's second-most-traded currency is also a risky bet, although speculators' positioning is pretty neutral right now, CFTC data shows.
The unsatisfying conclusion for traders is that there may be no clear successor to the yen as the low-yielding, funding currency of choice. It’s one more reminder that the era of ultra-low rates and relative predictability is over. The investing world is less certain and more volatile — and investors will need to get used to it.
(The opinions expressed here are those of the author, a columnist for Reuters)
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By Jamie McGeever
ORLANDO, Florida, Sept 9 (Reuters) - The Japanese yen's remarkable surge has left foreign exchange traders and speculators with a burning question: which currency should fund their carry trades?
The FX carry trade refers to borrowing in one low-yielding currency to buy assets denominated in a higher-yielding currency. Relative policy rates, bond yields, volatility, and future rate expectations typically determine the cost and profitability of these trades. For years, the currency used more than any other to fund them was the yen.
Until now.
Japan is emerging from years of deflation, zero interest rate policy (ZIRP) and negative inflation-adjusted bond yields. The yen's JPY= rally to a seven-month high this week, driven by expectations of faster Bank of Japan policy tightening and growing bets that Japanese investors could repatriate funds, follows another bout of official intervention in late July. Selling the Japanese currency is no longer on a likely, one-way path lower.
Where do traders turn now?
