A return to honest carry…and volatility

By John Kicklighter

We are starting to see a glimmer of the return to carry in the foreign exchange market with the Federal Reserve now on the taper path. We even have seen the first rate hike amongst the developed world’s central banks as the Reserve Bank of New Zealand lifted rates. This is an important turning point for the global financial markets, but it is particularly critical for currencies. Yield establishes a hierarchy for global capital flows while also engendering greater volatility by fostering competition and simultaneously draining support built up through moral hazard. The road out of the deep stimulus trenches will be a long one, but the early moves are often the most lucrative. Establishing who is leading and lagging in this race will be a key assessment of currency performance moving forward. At the same time, these changes could also provoke turmoil in a delicately balanced backdrop of speculative positioning. We have seen equities charge to record levels, tepid carry trades leveraged to multi-year highs and high-quality bonds swapped out for their high yielding counterparts. With rates of return (interest, dividends, yield) having collapsed in the wake of the financial crisis, market participants have had to take on greater risk to generate returns on par with—much less better than—benchmarks like the S&P 500 (CME:ESM14). This has led to years of stockpiling risky exposure and building leverage to unseen heights. “Nowhere else to go,” (below), shows the gearing that has set the foundation underneath the remarkable performance. A Balancing act In an ideal world, economic and financial conditions would catch up to speculative positioning and substantiate the levels and exposure markets have sought. Yet, “ideal” tends to be academic rather than practical market application. Where is the tipping point for the grander scale of risk vs. reward? How proactive will the world’s monetary policy leaders be in trying to curb or prevent the scale down in risk? Many central bankers, political officials and prominent economists have voiced their concern over what the removal of stimulus can do to the global markets. Yet, the costs accompanying QE3 are also starting to be taken more seriously amongst their ranks. Some vocal hawks (such as Dallas Fed President and voting FOMC member Richard Fisher) have even voiced concern that such extreme accommodation has distorted markets by encouraging excessive risk taking (see Cover Story, page 14). And though his is not a popular opinion amongst his international colleagues — at least not publically—concerned central bankers like Fisher have even said the situation is so unbalanced that they support a withdrawal of the extracurricular support even through a significant market correction. This evolving view is important to appreciate. The shepherds of the market are tacitly—and in some cases explicitly—acknowledging the excesses of the market. Furthermore, they are committing to letting some of the air out to prevent another financial disaster and a stimulus-resistant strain of investor fear. In this way, monetary policy can spark another wide-spread shift in speculative sentiment, but this time it is a bearish threat. In the event of a broad deleveraging move, the forex market will quickly realign to its traditional risk positioning. Those currencies that have suffered under the monikers of “safe haven” or “funding currency” during the past five years will be best positioned to gain. The U.S. dollar is undoubtedly the favored refuge should fear leverage appetite for liquidity. The Japanese yen fits the mold a little differently as it was used to build the carry trade, which would thereby appreciate as the position was unwound. Alternatively, the market’s investment currencies, such as the Australian and New Zealand dollars, will be most exposed while those that took advantage of low liquidity conditions to advance (Euro and Pound) would similarly face headwinds. U.S. Dollar: Coming from behind Just a year ago, the U.S. dollar (NYBOT:DXH14) was considered the most stimulus-logged currency amongst the majors. The Fed’s unprecedented quantitative easing programs had driven yields down in the United States while simultaneously ramping up appetite for higher risk globally. Yet, the central bank has headed towards the light since the fateful Dec. 18 FOMC meeting, when  the group announced its first reduction in the open-ended QE3 program—a $10 billion reduction that left the monthly purchases at $75 billion per month. More importantly, as the weeks and months passed by, the central bank made it known that a steady reduction in its purchases was the status quo as it cut another $10 billion in the first meeting of 2014. Altering their pace to disarm would require a substantial change in economic circumstances. In the early stages of the taper, the dollar seemed to take little joy out of the change. That was in part due to a buildup of expectations into the turning point. However, as the wind down continues, impact will be drawn into greater relief, especially if other central banks maintain or expand their own efforts. Eventually, the market will start to see the specter of the first rate hike from the Fed out on the horizon. Forex and rate markets are forward looking, especially when it comes to yields, so that time frame will draw speculative waves well before it is realized. According to a Reuters’ poll conducted in early March, approximately 51% of economists surveyed expected the first hike to happen in mid-2015. Around 22% said it would happen earlier. In the scope of scenarios, a rate hike from the Fed would bolster the dollar’s appeal as it moves up the carry curve even though its safe haven appeal may be undermined by the steady conditions that would foster buoyant interest rate forecasts. Then again, a market-wide speculative correction could leverage its dormant safe haven appeal (see Dollar volatility,” below). In other words, the greenback is very well positioned, and the worst version of its future is a market that is stuck in the doldrums for the near future. Euro: ECB hopes for status quo Few currencies have benefitted more from the quiet and consistent market conditions we have seen over the past quarters. Low volatility and a reach for yield have helped gloss over investors’ eyes so that the troubled state of the Eurozone’s member economies, the lingering exposure of its financial markets and the excesses of its assets are readily overlooked. While the Fed has started to move to reduce its stimulus injections, the ECB has actually seen its balance sheet contract. This is not a proactive effort on their part; rather it reflects regional banks repaying the exceptionally low yield, three-year loans the central bank was offering during the height of the region’s financial crisis via the Long-Term Refinancing Operation programs. This stimulus drainage has in turn lead market-based yields—like the Euribor rates—to rise. While still modest, the carry shift is noticeable in the near-zero-rate environment we have suffered through. Another effect of the stimulus drain, though, is a reduction in extra liquidity for the banking sector. That is a risky position even if regulators are confident in the outcome of the stress test results due later this year. Furthermore, it adds to the uneven economic conditions between members like Germany on one side and Greece on the other. Perhaps the most dangerous circumstance for the euro is founded on the same elements that have led the S&P 500 to its nosebleed levels. The chase for yield started to really hit its stride at the end of the Eurozone financial crisis. With lending rates on both the sovereign and corporate level swelled by the fallout, ambitious investors seized the opportunity. Taking advantage of the overindulged “tail risk” in the region could be called reasonable. Yet, the market took it much further than that as capital continued to flow in. In fact, the speculative drive was so aggressive, that short-term yields (two-year) sovereign debt for Spain and Italy—with an unemployment rate above 25% and the largest debt load in Europe—hit record lows (see “Pigs in a blanket,” below). This is as much a leverage position exposed to volatility as any other. And, fear here could cause the euro a lot of pain. Ye olde BoE In the annals of central bank history—at least before the Great Financial Crisis—the Bank of England was considered one of the most aggressive policy groups. It would change direction and tempo with rates far more readily than most of its counterparts. That badge of honor has faded significantly since the developed world ushered in its zero-rate policy, but the market is starting to recall some of the glory days as of late. Since last July, we have seen an abrupt change in U.K. economic activity, rate expectations and the pound. Having avoided a triple-dip recession, the U.K. economy instead charged an impressive recovery and a new BoE Governor (Mark Carney) wrote off the need for further stimulus. As the situation progressed, optimism turned into hard-boiled rate speculation. Though the central bank repeatedly reiterated a time frame for returning to a tightening regime that was in line with what the Fed was projecting, the market believed their hand would be forced and a hike would be pursued earlier than promised. Rate premiums have swelled substantially underneath the sterling, and traders are looking for some vindication for their positions. Feeling somewhat exposed, if data were to soften and justify the BoE’s original time frame or financial trouble distract them to more pressing issues, the bearish implications for the currency could be quite substantial. Yen for stimulus and risk One of the success stories of the forex market over the past few years is the incredible reversal from USD/JPY and the yen crosses. Rounding off of record lows, many thought the move was long overdue. However, the circumstances for its recovery may have put the currency and its pairings in a risky position for the future. There were two prominent themes that helped the yen crosses through the incredible 20% to 45% recovery experienced since the third quarter of 2012: the complacency of risk trends coupled with the appetite for yield and the Bank of Japan’s stimulus vows. The BoJ implemented a stimulus program that would eventually rival the Fed’s own massive program, and the depreciation factor on the currency was not missed. Traders jumped on the opportunity to front-run the manipulation. Yet, the capital inflow far outstripped the yield these trades have provided historically (see, “Who is carrying who?” below). Like all other over-exposed risk trades out there, the yen crosses are highly exposed to a risk unwind (see “Vulnerable correlations,” below). The biggest complaint from traders over recent years was a lack of real fundamentals and the risk on/risk off world that led to sharp reversals. With various Western economies at different stages of recovery, there appears to be greater uncertainty as far as stimulus, which should provide currency traders plenty of opportunity in 2014.

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