Cracks In The Carry Trade

Earlier on Wednesday, we noted that multiple crowded trades have been under pressure of late and one of those trades is obviously the overcrowded short in the dollar.

The greenback, having put in a lackluster performance in 2017 and having had the rug pulled out from beneath it earlier this year both by the Trump administration’s trade “strategy” and by the deteriorating U.S. fiscal position (which is expected to put America in worse shape than Italy by 2023), has gotten a boost lately from a persistent Fed and from a renewed positive correlation with 10Y yields, which have of course risen beyond 3% for the first time in four years.


“USD shorts could be vulnerable in the near term, despite the dollar’s structural weaknesses,” BNP’s Michael Sneyd wrote, in a note out last week.


The MSCI Emerging Markets FX Index fell for a fourth day on Wednesday, while EM equities are under pressure as the stronger dollar and rising U.S. yields weigh on sentiment for developing market assets.

As Bloomberg writes, this is putting pressure on the ubiquitous carry trade. Specifically, Natasha Doff notes that the Bloomberg FX carry index for eight emerging markets “has given up all its 2018 returns.”

This is just another manifestation of something that everyone seemed to assume would work forever having suddenly stopped working. If that reminds you of the short vol. debacle, it should.

“As with the short-volatility trade, the carry trade is a crowded trade and the unwinding should lead to meaningful moves in the market in our opinion,” Nedbank’s Neels Heyneke and Mehul Daya write, in a note dated Wednesday.

Here’s their take along with the attendant discussion on a topic that’s near and dear to their analysis: global dollar liquidity…

Via Nedbank

In a world where the change in the credit (money) cycle is much larger than the change in the real economy it is absolute necessary to understand how changing liquidity drives the economy and markets.

The US 10yr is against a major 30-year support and we do not believe a break higher will be sustainable. The rising world risk-free rate (discount factor) of the last 18 months is now taking its toll.

For the first time since the start of 2016 (when the risk-on phase started), dollar liquidity has rolled over. Stock markets are highly correlated to this change in dollar liquidity.

A stronger dollar (which is a consequence of this contraction in global liquidity), would eat into the performance of carry trade returns.


We monitor the Australian dollar as a proxy for the carry trade as it is the preferred destination for this trade. The AUD benefitted from the carry trade since the start of 2016, but has now broken out of this bull trend.


The Bloomberg EM FX carry index has broken down out of a wedge, and we believe the ABC corrective rally in EM currencies is now over. A break out of bull trend at 260 would confirm this reversal. We had to keep the option open for one more rally up in EM currencies as long as the wedge was intact (as wedges are extremely seldom reversal patterns). The probability of one more rally has now been negated.


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