17/10/2008: Ignore fundamentals and they will seek revenge

This is a basic rule of investing. It has been recently once again proven right. This time it was in the foreign exchange market.

During the last five years at least foreign exchange markets were dominated by a practice called “carry trade”. Carry trade consists of borrowing funds in a low- interest rate currency and investing the proceeds in a high- interest rate currency. For example taking a mortgage in the Swiss Franc characterized by a very low interest rate and buying real estate in another country whose interest rates are higher. The yield difference between the two countries or the two currencies represents a gain if the exchange rate does not move to such an extent that it will erase the interest rate differential. If such a strategy is broadly adopted, as was the case in the last couple of years, then the price value of the low-yielding currency will decline and the price value of the high-yielding currency will go up.

This sounds like a money-spinner but, as we all (should) know, there is no such thing as a free lunch, or a perpetual profit maker. So where is the flaw in this practice?

First and foremost, one needs to acknowledge that interest rates are usually a reflection of inflation expectations. The countries, which are seen as having a low inflation track like Switzerland or Japan enjoy usually comparatively low interest rates and conversely countries with a less optimal inflation track, like Australia or New Zealand have comparatively higher interest rates. According to the purchasing power parity, low inflation countries will see in the long run their currencies strengthen against higher inflation countries. In fact over a period of 20 years the Swiss Franc and the Japanese Yen have clearly appreciated against almost all other currencies in the world.

Second, a low interest rate is also a reflection of the fact that a country is seen as safe and stable. This explains why usually developed countries have lower interest rates than emerging markets and have in the long run currencies, which are more stable.

Despite these fundamental explanations, why in the long run low yielding currencies tend to appreciate against high yielding currencies carry trades enjoyed the investors’ favor of investors in the last couple of years, reflecting their robust risk appetite. The exchange rate between the Japanese yen and the Australian dollar, which encompasses one of the more favored carry trades – sell the former and buy the latter – was almost mimicking the evolution of the Standard & Poor’s 500 equity index. Therefore there was a close relationship between successful carry trading and equity performance, one gauge of overall market sentiment.

Like every other risky strategy carry trades have been hit hard by the ongoing financial crisis to the extent that we consider them to be over by now. Over the last month alone the high yielding and once favored Australian dollar lost more than 40% against the low yielding and once despised Japanese yen.

In our view, carry trades are now clearly out of fashion on the currency market and it is not yet clear which new theme will drive the market over the medium run. Meanwhile, and at least as long as the crisis last we low- yielding, safe-haven currencies like the Japanese yen and the Swiss franc over higher- yielding currencies, like the euro, the British pound or the Australian dollar.