Decisions, decisions. After wondering for months what US Federal Reserve chair Janet Yellen would do about rates, the market now seems confident she will move from words to actions and raise them next month, following that superstrong payrolls data last Friday.
But what about Mario Draghi? Does the European Central Bank president follow through with his heavy hint from last month that he would ease monetary policy further?
After all, as ex-ECB member Lorenzo Bini Smaghi said in the FT this week, the euro’s dive towards parity with the dollar on the back of US rate rise expectations is in part doing the ECB’s easing job for it and “might make further measures unnecessary”.
But Mr Draghi seems determined to keep downward pressure on the euro. On Thursday, he again voiced worries about “clearly visible” economic risks to the eurozone, adding that signs of a reverse in low inflation “have somewhat weakened”. The euro promptly fell.
But the market wants more than words. That much is clear from the carry trade, when investors borrow money from low interest rate countries and buy currencies or assets in countries where rates are high.
The ECB’s main refinancing rate stands at 0.05 per cent and the euro is expected to weaken further against the dollar by the end of the year. In Brazil, meanwhile, investors can get a return of more than 14 per cent on their money. On the surface, the ingredients look perfect for a textbook carry trade.
But investors are not biting. The carry trade is commonly referred to as “picking up pennies in front of a steamroller”, and for good reason. Swings in currencies can quickly wipe out any gains from interest rate differentials, leaving investors coughing up to fund unexpected losses.
And at the moment, the carry trade market is still reeling from having its fingers burnt earlier this year from China’s renminbi devaluation.
Deutsche Bank’s carry trade index illustrates the risk. The index hit its lowest point for six years in August. In the year to date, any carry trader would have lost 10 per cent of his investment.
“Last year, borrowing in euros to fund long positions elsewhere was a very popular and consensual idea,” says David Bloom, forex strategist at HSBC. “Then China devalued the renminbi, the euro went up, emerging markets currencies got smashed, and you got creamed.”
The market has learnt its lessons and is reluctant to engage in carry trades just yet, for fear that the ECB fails to act in December and the euro shoots back up, Mr Bloom adds.
Peter Kinsella, EM strategist at Commerzbank, agrees. “What we’ve learned this year is that carry doesn’t compensate,” he says.
“The move in the underlying spot has been negative and aggressive for EM currencies, where people typically went long.”
Carry trades rely on low volatility. “When volatility is low, you can sit on your beach towel and pick up 10 per cent each year through carry, no problem,” says Mr Bloom.
But right now, volatility is relatively high, deterring carry trade investors. JPMorgan’s forex volatility index has risen 15 per cent since July.
“The amount of carry on offer could easily be wiped out by two days of spot movement,” says Paul Lambert at Insight Investment Management.
“What matters is carry divided by volatility, and at the moment, where we see high rates, we also have high volatility.”
Even if volatility was benign, would investors feel comfortable about where to invest their borrowed money? For while several currencies offer attractive low borrowing rates, few offer a secure environment and high interest rate in which to invest.
That is why Eric Stein at Eaton Vance Management is avoiding carry trades. “If fundamentals in higher yielding countries improved, that might make us more apt to add FX carry to our portfolios,” he said.
Turkey is one place where carry trade investors are placing their bets, according to Deutsche’s forex positioning index. “People have been buying selectively in EM FX,” says Deutsche’s Nicholas Weng. “But I don’t see very strong evidence for it.”
Risk aversion is easing. That adds logic to the carry trade, says Simon Derrick of BNY Mellon, and makes the euro “the natural funding currency of choice”.
But he cautions that while the dollar should strengthen over the medium to longer term, “we do find ourselves wondering whether the moves will prove as strong as some suppose”.
If the carry trade lights up, the euro’s fall will continue. But the market looks likely to wait for a bit more certainty from Mr Draghi.
“He needs to deliver,” says Nomura’s forex strategist Charles St-Arnaud. “If he under-delivers, there will be a lot of disappointment in the FX market and you’d see a decent-sized rally in the euro.”
The time for rhetoric is over. The market expects Mr Draghi to show decisive action.