Good and Bad Currency Carry Trades - We need more thinking on currency portfolio construction

Carry strategies are core to cross-sectional currency trading; buy the high-yielding currencies and short the low-yielding currencies. This strategy works but has been subject to negative skew and underperforms during crises or periods of high volatility. For researchers, the concept of currency carry is in conflict with uncovered interest rate parity and has been a puzzle which is only deepened without good pricing models to explain the risk premia. This puzzle has only gotten murkier with a paper called "Good Carry, Bad Carry". 

There are prototypical G10 carry trade currencies (AUD, CHF, and JPY) with JPY and CHF usually used as funding currencies with low rates and AUD often serving as a high yield currency. For the longest time, the sort of carry currencies would have showed same exposures for decades. A carry portfolio will always hold the rate differential extremes.  

However, it was found that if you exclude these three currencies from a G10 currency carry sort, you will get portfolios with higher Sharpe ratios and lower skew. Limiting the set currencies to exclude specific currencies will actually improve your portfolio efficiency. This is not supposed to be how a cross-sectional carry sort should work. Placing restrictions on currencies included in a portfolio will create good and bad currency mixes with the bad portfolios having lower Sharpe ratios and negative skew.  

The authors tested a number of variations for good and bad and get the same results. Hypotheses based on current carry thinking were tested for this anomaly but were not able to draw any definitive conclusions. Good carry portfolios reduce tail risk and have better return to risk. Investors need to think beyond simple sorts or look at risk through different criteria.

The researchers found that past carry predictors can explain bad carry portfolios but not the good carry portfolios. Good carry has unique return characteristics that are not driven by established thinking concerning carry. Bad carry is eroded by exchange rate changes while good carry is predominately driven by the yield differentials. Good carry is correlated with a dollar liquidity story since these portfolios always hold dollars risk but again this liquidity story is not a primary driver.

There are unique features with some currencies like JPY, CHF, and AUD that make them less carry attractive. Using a wider sample of currencies may not be helpful, and our understanding of currency carry needs further refinement. 

What you need to know about "crowdedness" risk and return

A Yogi Berraism: At Ft. Lauderdale Yogi was listening to his teammates talk about a restaurant in the area. Said Yogi, “Aw, nobody ever goes there. It’s too crowded.”

There always has been a significant interest in trade crowdedness, or more specifically, the big trades of hedge funds. However, there is a yin and yang with crowdedness. We want to know what smart money is doing so we can follow it, but we realize that if everyone is following the trades of others there will be a tipping point where the crowd will kill the golden goose trade. This is another way of saying the mix of buyers and sellers has an impact on the future direction of prices especially if there is a crisis. The structure or composition of funds and markets matters.  

Now crowdedness has not been well-defined, but a good measure is the numbers of days to liquidate equity positions held by hedge funds. Research has found that crowdedness as measured by the position-taking of hedge fund managers through the 13F filings will generate positive excess returns of approximately 300 bps versus stocks that are not crowded. (See "Crowded Trades and Tail Risk") 

This new crowdedness factor seems to be independent of other key equity risk factors. The collective wisdom or information edge of hedge fund managers along with their buying power seems to find stocks that will generate good positive relative returns. But there is a catch.

A close review of the crowded portfolios of hedge fund managers shows strong decline in returns or drawdowns when there is a negative market environment or crisis. Crowded trades do well until the market faces stress that may require liquidation. Investors will receive compensation for holding these crowded trades, but they will pay a price when there is a flight to the exits like during the GFC. Trying to piggy-back on the smartness of others can work, but when this collective smartness needs to find the exits, the market decline will be strong. The negative case is very specific, but it does suggest that following the action of others will have downside during a market unwind.

Geopolitical risks - The spillover to markets is real

 

Geopolitical threats create risk and uncertainty. This seems intuitive and can actually be measured through tracking geopolitical risk indices. These threats can be linked to market reactions, so investors can measure and act on these evolving risks. Below is the widely used Geopolitical threat index developed and updated by Matteo Iacoviello. It uses key word searches from leading newspapers around the world to measures geopolitical threats and acts. In many cases, elevated threats will impact financial markets.

A common theme of my investing thesis has been to focus on the nexus between risk, uncertainty and pricing. If uncertainty increases, it will carry over to market risk as measured by volatility. This increase in market risk will add to market dispersion, change correlations, affect risk aversion and sentiment, and change risk premia. Even if market prices don't move significantly, there will be a change in the wings of return distributions. 

Markets that engage in global trade in sensitive geopolitical area or have been perceived as a place of safety should be more sensitive to changes in these threats. Threats go up and there should be a flight to safety and a movement out of risky assets. 

A causal link from geopolitical threats spillover to oil price volatility and gold moves has been found with recent research. Similarly, threats influence the capital investment decisions of companies. This alternative data index can help with global macro decisions.

See recent research:

“Are geopolitical threats powerful enough to predict global oil

price volatility?” 

Environmental Science and Pollution Research https://doi.org/10.1007/s11356-021-12653-y

“Geopolitical Risk and Corporate Investment” Ruchith Dissanayake, Vikas Mehrotra, and Yanhui Wu

“Hedging geopolitical risk with precious metals” Dirk G.Baur and Lee A.Smales Journal of Banking & Finance Volume 117, August 2020,

“Forecasting realized gold volatility: Is there a role of geopolitical risks” Finance Research Letters Volume 35, July 2020

Margin credit - More complex than just saying it is rising

With the prime broker loses on levered positions, market talk has focused on overall stock margin; however, looking at some of the numbers suggests that the story is more complex than saying leverage is higher. 

We are certainly not arguing that the economy is not levered. The low interest environment is all you need to know. Cheap money will lead to greater credit usage. This is especially the case if the financial instruments being purchased are trending higher. Nevertheless, financial leverage is not the same as borrowing for long-term investment in plant and equipment where the measurement of uncertain future cash flows in an illiquid investment makes for a more difficult assessment.

The quick take:

1. Margin debt balances have increased significantly since the March 2020 crisis. Money is cheap and plentiful, and investors are taking advantage of the opportunity. 

2. The debt balances relative to the SPX market capitalization are increasing but the numbers are below the highs seen two years ago. Leverage has grown with the strong market, but the overall levels are not at extremes.

3. Free credit balances have grown from 2019 lows. There is money available to invest and it not as though all investor cash is being used to boost leverage. Margin accounts are getting the benefit of the rise in equities, so free cash levels have not seen excessive declines based on extreme speculative desires.

In the unregulated swaps markets, the world can be quite different, so any generalization on margin usage should be tempered with a fuller picture. In the regulated market, the leverage usage is more controlled.