FX Carry is back

Higher interest rates are back, and so is FX Carry. Do we think this presents a good opportunity for investors to derive uncorrelated alpha returns?

This year has seen the world economy entering a new paradigm of rising global inflationary pressures resulting from a) a demand shock from the expansionary fiscal policy during Covid, b) a supply shock from labour market disruptions and supply chain interruptions, and c) excessive global monetary policy liquidity.

As a consequence, interest rates are rising, yield differentials are widening, and the central bank liquidity withdrawal marks the end of the quantitative easing era and a return to a conventional monetary policy framework.

As a result, after a 14-year hiatus, FX carry is back, providing strong returns and is again an attractive return strategy to adopt within a multi-asset diversified portfolio.

In the majority of the period since floating exchange rates commenced in the 1970s, a large body of literature indicates that the FX carry trade has statistically and economically significant positive excess returns and, in many periods, has provided a Sharpe ratio double that of major equity markets.

This has particularly been the case before the Global Financial Crisis (‘GFC’) of 2008, after which carry was effectively eliminated by the financial regime established in response to the financial and economic crisis.

The passive approach to an FX carry strategy involves buying the top 3 G10 highest-yielding currencies and selling the bottom 3-yielding currencies. This results in a portfolio of 6 currencies. A comparison of returns from this passive strategy in two distinct periods is shown below.

Source: Millennium Global and Bloomberg. All representations are for illustrative and educational purposes only. Performance is for the period 28 February 1989 to 31 December 2021. Past performance is not a guide to future returns; the value of investments may also fall and rise.

As we emerge from the post-GFC, post-pandemic era, we believe that this new higher interest rate regime is likely to persist for many years to come as systemic factors such as the reversal of globalisation, shifting demographics, and the costs of the climate change transition will keep interest rates elevated on a structural basis.

While the environment is highly conducive to attractive FX Carry strategy performance, active management rather than a passive approach can materially enhance FX Carry returns in our view.

At Millennium Global, we have developed an Enhanced FX Carry strategy that uses proprietary quantitative techniques that seek to increase performance and mitigate drawdowns to provide superior risk-adjusted returns.

• Return enhancement is achieved via modulating FX carry currency exposure weights according to signals from our proprietary quantitative models.

• Drawdown mitigation is managed via an “FX volatility switch” to moderate carry exposure during high volatility regimes, or ‘risk off’ periods.

• Correlations with traditional and alternative asset classes are expected to be very low while liquidity within the strategy remains high, and so the strategy represents an attractive addition to institutional multi-strategy portfolios.

We are excited about the prospects for FX Carry strategies over the coming years. Don't hesitate to contact us if your considering deploying this strategy as part of your diversified portfolio or visit our dedicated strategy page here.

The views and opinions expressed in this content are correct as at September 2022. The value of any investments may fall as well as rise. This information is intended for Professional Clients only, not target retail clients. This information does not constitute an offer to buy or a solicitation of an offer to sell and does not constitute an offer or solicitation in any jurisdiction in which such a solicitation is unlawful or to any person to whom it is unlawful.

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