Forex Carry Trade Unwinds Over 3 Percent, but History Says it May Go Further

The widely popular forex carry trade has recently fallen from previous heights, forcing sizeable drawdowns in portfolios that held long-carry positions. Going long the three highest-yielding G10 currencies and short the three lowest-yielders produced a 3.1 percent decline in a matter of days. Viewed from a historical standpoint, however, this is actually one of the smallest major drawdowns since the inception of the Euro.

Looking at the table below, we notice that the recent skid is actually only two-thirds of what we saw from late February to early March.

The chart below gives a visual representation of just how minor this drawdown has been. Using the inception of the Euro as a starting point, we see that there have been nine instances in which the carry trade has lost three percent from a previous peak. The most severe carry trade tumble was seen from late 2005 to the middle of 2006, when the Japanese Yen and Swiss franc embarked on extended rallies against their higher-yielding counterparts. Had the trader held onto such positions through the same period, he or she would have suffered an unleveraged 10.5 percent equity tumble. This instance was likewise the longest-lasting downtrend through the past 8 years, at 171 days from peak to trough and 238 days from trough to recovery.

[B]Carry Trade Rout Remains Small by Historical Standards[/B]
As a more recent example, the late-February early-March flight to safety across financial markets led to a similarly pronounced 4.8 percent drawdown in portfolio equity. The pronounced rout lasted a mere 11 days from peak to trough, matching the shortest 3+ percent tumble since July of 2003. As we all know, however, the carry trade strategy was quick to make a recovery in subsequent trade?setting new highs in a mere 28 days from the established bottom. In fact, the overall strategy produced an impressive 12.7 percent return from its March lows to July peaks. The key question remains whether we can expect a similarly speedy recovery through the short term.

Given that the recent carry rout remains small from a historical standpoint, there definitely remain risks to the downside through medium term trade. Though carry trade pairs have shown signs of stabilization, it is entirely too soon to call a bottom to the drawdown. Indeed, with risk-aversion levels still at exceedingly high levels, it seems somewhat likely that we will see continued rallies in the Japanese Yen and simultaneous declines in higher-yielding pairs. Looking at the carry trade from a length perspective, the past 8 years of trading have seen drawdowns last an average of 57 days from peak to trough. Of similar concern, the previous eight drawdown periods have taken a longer average of 130 days to establish fresh record peaks. This implies that a person who bought into the portfolio at the top would have to wait nearly two months to go back to break even, which leaves the leveraged trader at a fairly significant risk of a margin call. Trying to buy the bottom on the carry trade tumble is certainly a more appealing strategy, but this will surely prove difficult given overall uncertainty across financial markets.
[B]Investors Remain Risk Averse: Can They Change?[/B]
To gauge whether a return to risk appetite is likely, we may look at the performance of highly risky assets versus those with much lower risk profiles. Arguably the safest market asset in the global economy, the US Treasury Bond represents the bellwether of market speculative sentiment. If markets are highly averse to taking on speculative bets, then Treasury Yields will almost definitely dip. Conversely, strong performance across volatile trading instruments will usually leave Treasury Yields lower as investors shift out of the low returns of government debt.

The chart above shows us the relationship between risk-free government bonds and the speculative corporate bond market. The line in white represents the 10-year Treasury Yield minus that of similarly dated corporate debt. We see that as markets grow risk averse, investors demand a higher return on the unsafe corporate debt as compared to the risk-free government issues. The line in orange plots the USDJPY through the same period, and we can see an unmistakable relationship between the yield spreads and the risk-sensitive US Dollar-Japanese Yen exchange rate. Though spreads have shown signs of stabilization in the past days of trade, we see that they are still on a pronounced tumble through the medium term. As one of the many barometers for risk appetite in US financial markets, we would clearly need to see this trend reverse before we see a worthwhile bounce across Japanese Yen pairs. And, as one of the critical components to the carry trade, investors will have to wait for such a Yen decline to return to profitability from pre-drawdown levels.