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Keep calm and carry on is the broad message from the currency market thanks to the generous support of central banks.
Borrowing a currency at low interest rates and buying a rival sporting much higher short term yields is a nice little earner for investors, so long as market volatility remains quiescent.
As the European Central Bank becomes more accommodative with negative deposit rates and further easing expected this summer, the backdrop remains enticing for carry trades. Particularly as the US Federal Reserve appears set to keep its benchmark rates at very low levels for some time, after a May jobs report merely met expectations and plenty of slack remains in the world’s largest economy.
The supportive backdrop of low interest rates among the big three currencies, the dollar, euro and yen, is likely to result in broad market volatility declining further over the coming months, fuelling higher equity prices and no doubt arousing worries about financial stability.
A self-reinforcing cycle of ever lower volatility will continue benefiting emerging markets in the coming months as this is where the prime candidates for carry trades reside.
A glance at global two-year yields shows the days of alluring yields on eurozone peripheral government debt are long gone – with two-year Italian and Spanish yields sitting at around 0.5 per cent. In contrast, the hunt for yield looks a lot better when two-year yields sit at around 8 per cent, a group that includes Turkey, Russia, Ukraine and India.
Even better is Brazil with an 11.5 per cent two-year yield and the real has sharply appreciated against the dollar as volatility has eased since February.
A similar story is playing out with the Turkish lira, South African rand and India’s rupee and the trend has plenty of upside as carry trades exert a calming influence for now.
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