DB FX Daily: Carry Correction Over?

[RTFX-Trading]

FX Daily: Carry Correction Over?

Carry Correction Over?

The rebound in USD/JPY yesterday has shifted market attention back to the carry trade outlook and the extent to which recent strength can be sustained. Indeed, a further rally of 2% or more will take a top-3/bottom-3 G10 carry basket back to the year highs reached at the end of last month. In spite of this, we would be cautious in calling for an end to the recent correction just yet. Looking at the correlations between carry trades and both equity and bond market performance, these remain at very elevated levels suggesting that we have not yet exited the current episode of risk aversion which has seen a sharp pickup in correlation across most asset classes. This would mean that carry is not immune to moves in any number of external drivers and therefore remains vulnerable to sudden changes in sentiment across financial markets. Our first marker for an end to the current episode of risk-aversion would therefore be a drop-off in the cross-asset correlations that would allow us to asses USD/JPY price action on its own merits.

A second marker which to us would indicate market expectations of a more sustained recovery in carry trades would be a steepening of the USD/JPY vol curve, which remains sharply inverted. As the second chart at right shows, 1m USD/JPY implied volatility remains much higher than longer-term tenors, indicating that the market is still concerned of a possible continuation in the recent USD/JPY sell-off in the next few weeks. Indeed, recent vol curve inversion is much higher than that observed during the JPY rally in April last year, when USD/JPY sold-off by more than 7% in the space of a few weeks. A fall in short-dated volatility would therefore be an indication of a perceived drop in the level of risk associated with G10 carry and of renewed willingness to increase carry trade positions by market participants. That said, given our overall negative carry view for this year, we would look at a sustained move lower in short-dated FX implied volatility towards the lows seen at the start of this year as an opportunity for carry bears to enter short carry trade positions, as it would indicate renewed market confidence in G10 carry and would thus increase the potential downside risks of a new correction lower.