Forex Carry Trade - The Latest Strategy To Blow Up

Macro Man sure is glad that he finally got on the distribution list for “the memo.” Yesterday’s memo about the breakdown of correlations and the underperformance of carry and EM proved to be timely; the Illuminati have done their job well over the past twenty-four hours.

Currency de-leveraging has had a particularly strong impact on EUR/USD; given that the euro was directly or indirectly the beneficiary of speculative flows funded by dollar borrowing for much of the past six years, the unwinding of these trades has been nothing short of spectacular. Macro Man’s post-holiday expectation that the USD would range-trade has proven to be spectacularly incorrect; fortunately he did not follow up with any sort of nonsensical vol-selling strategy. Was it really two years ago that he was moaning about the lack of volatility? EUR/USD has fallen 20% in 3 months!

From a long-term perspective, the rally in the dollar has actually been pretty modest; the chart below shows USD/DEM monthly candlesticks since 1980. EUR/USD could sell off quite a bit further and the dollar bear market remain intact. Yet the buck seems to move in seven year cycles, and the current bear seems to be at or past its sell-by date. With the situation in Europe no better than the US-and one could argue the future newsflow will be worse- might the current unwind represent the genesis of some sort of deflation-driven dollar bull? (Think JPY in the first half of the 90’s.)

In any event, it looks like FX carry is the latest strategy to blow up, following a distinguished line that includes high-yielding structured credit turds, equity long/short, fixed income RV, and energy/commodities. The chart below show the performance of a simple G10 carry basket as of last night- it should lurch down again on today’s close.

The real pain, however, is being felt in EM. The Turkish lira has taken a beating, and anecdotal evidence suggests that local corporates are short USD. Latan America looks ugly, as does Eastern Europe. And Asian sovereign CDS blew up last night, including China (owner of the odd $2 trillion or so in cash), which rose 70 bps.

And of course, it wouldn’t be any sort of crisis if Argentina didn’t default, a development that now looks imminent. So after FX carry and the EM miracle have been taken behind the woodshed for a beating, Macro Man is left to wonder: where are the remaining sacred cows to be taken to the abattoir, the pink flamingos that have yet to be hunted? Because Macro Man has little doubt that another strategy will, like those before it, bite the dust.

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