Citigroup says the carry trade is back, but with a key difference: hedge funds are borrowing US dollars rather than the yen for their wagers on emerging markets.
Investors have ramped up bets for more than three quarter points of interest rate cuts from the Federal Reserve this year. Combined with the Bank of Japan’s hike in July, that has damaged the old model of wagering on robust US growth and rock-bottom Japanese borrowing costs.
“We’ve seen our positioning sentiment on the US dollar starting to turn much more bearish,” said Kristjan Kasikov, global head of FX quantitative investor solutions at Citigroup. “An environment where people are speculating about rate cuts has fueled risk appetite.”
That’s a turnaround since the global slump at the start of the month when carry trades were pummeled. In a carry trade, investors borrow in currencies where interest rates are low and park the proceeds in riskier assets where rates are high.
Now, hedge funds using the strategy are picking the dollar over the yen as the funding currency, given the prospect of diverging rates in the US and Japan, Kasikov said.
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The greenback is trading at its lowest since March and hedge funds have been using it since Aug 5 to buy emerging market currencies, including the Brazilian real and Turkish lira, according to Kasikov.
In the first half of 2024, the dollar was climbing steadily as traders dialed back expectations that the Fed would aggressively ease rates. A Bloomberg gauge of the dollar rallied nearly 5% between January and June, while the yen fell to its lowest mark in nearly 40 years.
August’s sharp reversal — precipitated by the BOJ’s hike — led to a flurry of trading among hedge funds, which are typically able to move in and out of trades more quickly than large asset managers.
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Having staked out bearish positions on the yen in the futures and options markets since 2021, the hedge funds turned positive on the currency as the BOJ’s move pointed to a historic shift in rate policy, according to Commodity Futures Trading Commission data compiled by Bloomberg.
“Citi’s hedge fund clients have been unusually active this August with their recent FX trading volumes at the upper end of the historical range,” said Kasikov. Asset-manager clients, on the other hand, are trading less volume than usual.
Still, Citi anticipates only a short window for global carry trades to perform well as turbulence around the US presidential election could lead to another surge in volatility, Kasikov said.
“We’ve been concerned about the FX carry trade for a while now,” he said. “The US elections, the political calendar, will introduce more volatility to the market and risk aversion that will weigh.”
Charts: Bloomberg
