Carry trades – two-sided equation

There has been much talk about carry trades with the increase in credit risk spreads. Wider credit spreads suggest that there is a less risk appetite around the world and there will be less flow into high yielding currencies. There is also the other side of the equation, the funding currencies.

With the reduction in risk appetite we have seen a significant rally in the funding currencies for carry. The yen is off by 4.5% from its high in late June. Capital is coming back home, or there is a new conservatism by Japanese investors to keep cash at home. The same effect is happening with CHF which has appreciated by 4.5% over the same period. The short-term rate in Switzerland is at 2.5% which is 275 basis points less than the US and 150 and 325 bps less than Europe and Great Britain respectively.

It may not be surprising to see the funding currencies have greater changes in price. With many of the emerging market high yielding currencies in better financial shape than we have seen in the past, there will be less pressure to sell those positions. The credit risk story is significantly less for these high yielders. It is the lending currencies that may be hit harder for the simple reason that less flows will be drawn out of these currencies.