Carry On Carry Trades

After the slight scare with the subprime mess, which caused the USD to tumble, or more importantly causing the yen and swiss franc to rise - carry trades seem to be increasing again. The main target currencies were the Australian dollar, Indonesian rupiah, Indian rupee, New Zealand dollar and Philippine peso - i.e. carry trade was borrowing in yen or swiss franc to invest in the above mentioned currencies.

Yen-funded carry trades provided higher returns than those using Swiss franc loans because of the Asian country's lower main interest rate. The recent rise vs the USD from 120 yen to 109 yen would have scared many carry traders, but most would have been able to unwind to lock in gains. Now that the yen has stabilised, we are seeing more carry trades reopening positions because carry trades despite the inherent risks allow them to lock in 10%-12% gains per annum. For example by borrowing in yen and buying AUD, these trades can produce an annualised gain of 12%. One can borrow in yen at 0.5% and buying AUD will yield 6.5%.

In fact, if measured in volatility, these carry trades have a lower volatlity than stocks even. Of course, the danger is the sudden divergence in currency movements. The losses would be magnified if yen strengthens and AUD weakens. However, the recent risks and losses have been less than generally anticipated because when yen strengthens, the AUD and other targeted currencies also strengthen. There was only one losing currency and that is USD.

Not all carry trades are the same. The danger is the "underlying fundamentals" of the target currency. All things being equal, the following target currencies are ranked according to inherent strength in economic findamentals:

1) Australian dollar

2) Indian rupee

3) Thai baht

4) Indian rupee

5) Phillippine peso

6) Indonesian rupiah

7) NZ dollar

The lower the ranking the bigger the danger of the target currency collapsing. What carry traders don't want is a strngthening yen/swiss franc and a collapsing Kiwi dollar/ rupiah. Private investors dabbling in carry trades, do realign your strategies.

The yuan would have been the ultimate carry trade on a 6-12 months view. Borrow in yen at 0.5% and just park in yuan bonds or deposits giving you 3%-4% p.a. The beauty is the expected rise in yuan value on a 6-12 month basis. Alas, its difficult to get hold of yuan papers.

As a matter of fact, borrowing in yen and buying HKD in blue chip stocks (with 3-4% dividend yield) or good REITs would be an excellent trade on a 6-12 view. Even though USD may weaken further, thus weakening HKD owing to its USD-peg, the structural shift actually would push HKD stocks higher. Its atrade with a high level of risk though. Worth mentioning anyway.