FT Alphaville " Carrying liquidity as far as you can FX: it's a funny old market and its drivers can be difficult to discern. One way to try and pick out a few of them is to strip everything way and then stare fixedly at what's left. Uncovered interest rate parity is one way to do that. Essentially, it's the idea that the expected change in the exchange rate between country A and country B is equal to the difference in interest rates between the two countries. Or to put it another way: according to UIP, the expected carry trade return is zero because exchange rates move to compensate for the interest rate differential. UIP does tend to fail in the real world, where risk and rational expectations come into play. But for the purpose of analyses it can be very useful, especially in the short run. It is particularly handy if you want to look at the impact of shocks on exchange rates. The Global Rates & Currencies team at Bank of America Merrill Lynch think so and have used it to look at how big a factor carry has been to G10 currencies, particularly the Australian dollar, the Canadian dollar and the euro (our emphasis): A decomposition of daily EUR, CAD and AUD moves reveals that carry drivers have become modestly stronger. But, while the carry motive appears to have been a key driver of the AUD during the summer, it has been contributing little to EUR and CAD moves. The results show that interest-rate differentials were important drivers of the AUD in late July and August (Chart 1). They also seem to have supported the currency in recent days. This is not surprising, as carry attractiveness remains high. As our FX strategist Adarsh Sinha notes, 3mth carry-to-implied volatility ratio for AUDUSD has been elevated. As long as volatility remains low, carry factors could continue to support the currency. Meanwhile, on the CAD front, interest-rate differentials have done far less heavy lifting of late. Although increasing, carry drivers still account for only 1/5 of the 22-day average daily change. This matches our FX team view: John Shin sees the CAD being buoyed by risk appetite as well as commodity prices rather than carry flows. The story might have been different back in April, when the Bank of Canada surprised markets with hawkish statements. The UIP decomposition picks up meaningful support from interest differentials during this period (Chart 2). Also as expected, there is very little carry footprint on the EUR (Chart 3). Over the past year, the currency has been swayed by other complex factors, such as bank deleveraging flows, EM reserve management and risks aversion linked to euro area crisis management. The last time interest-rate differentials seem to have counted as a key EUR driver was in early 2011, when the market reacted to theECB's increased hawkishness and eventual rate hike in April (Chart 4) But then they say not to get carried away (which confused us a bit but there you go): The modest increase seen in the contribution of interest-rate differentials to EUR, CAD and AUD moves may continue to edge higher in the short term in response to Fed policy. But, looking further out, there are reasons to expect shifts in risk premium to be more dominant... Across the Atlantic concerns about the US's fiscal cliff should continue to build, affecting Canadian growth. CAD is likely to weaken in an environment where the US economy expands by only 1% in 4Q. Meanwhile, in Australia, anxiety over Chinese growth could weigh further on the AUD. Asian export growth hascontinued to surprise on the downside, worsening the backdrop for Australian exports. All told, by year-end our FX team looks for broad US dollar appreciation against these currencies, particularly since the impact of Fed QE may be less powerful this time, as concerns about the fiscal cliff weigh on the US and global outlook. And that's all fine as it goes... carry probably does have something to do with FX movements but certainly not as much as popularly assumed, as risk and safe haven effects tend to trump return considerations. This also gives us the opportunity to throw another carry-esque idea into the mix - one which might explain why carry persists as such a hefty FX meme (and which might also explain some of why UIP is wrong about zero returns). It's from Loriano Mancini, Angelo Ranaldo, Jan Wrampelmeyer and was thrown up by Vox earlier this month. They found that where the carry trade is concerned, funding currencies offer insurance against liquidity risk and that the liquidity risk factor has had a strong impact on carry trade returns. It comes down to liquidity spirals say Mancini et al: Contrary to common perceptions, all exchange rates experienced a significant decline in liquidity during the financial crisis, especially after the bankruptcy of Lehman Brothers. For the least liquid exchange rates, the liquidity evaporation was ten times more severe than for the most liquid ones. Forex illiquidity is not isolated to certain exchange rates. Market liquidities of individual currencies move together and are positively, but to different degrees, related to market-wide Forex liquidity. This commonality in liquidity implies that Forex liquidity is largely driven by shocks affecting the Forex market as whole rather than by idiosyncratic shocks to the liquidity of individual exchange rates. Forex market liquidity is in turn tied to market-wide liquidity of other asset classes such as equities and bonds, highlighting that liquidity shocks are a cross market phenomenon. They argue that losses due to FX illiquidity can be substantial and hit every investor or company that owns assets denominated in foreign currencies. And, significantly, liquidity risk in the foreign exchange market might also help explaining the profitability of carry trades: We call the link between currency return and liquidity risk "liquidity betas." As shown in Figure 2, low interest rate currencies exhibit negative liquidity betas, thus funding currencies offer insurance against liquidity risk. On the other hand, liquidity betas for high interest rate currencies are positive, hence investment currencies provide exposure to liquidity risk. The opposite signs of liquidity betas of high and low interest rate currencies have important implications for carry trade returns. When Forex liquidity improves, high interest rate currencies appreciate further, because of positive liquidity betas, while low interest rate currencies depreciate further, because of negative liquidity betas, increasing the deviation from UIP. During the unwinding of carry trades (i.e., when investors sell high interest rate currencies and buy low interest rate currencies), market-wide Forex liquidity drops and liquidity betas lead to further selling pressure on investment currencies, which exacerbates currency crashes. This finding is consistent with a flight to liquidity and suggests that investors may demand a risk premium for bearing Forex liquidity risk. Related links: Currency wars redux - FT Alphaville The euro's paradox - FT Alphaville The foreign exchange market: Not as liquid as you may think - Vox This entry was posted by David Keohane on Monday, September 24th, 2012 at 18:47 and is filed under Uncategorised. Tagged with carry trade, currencies, fx.