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Macroscope | As interest rates rise, G10 currencies could soon offer investors some fast and furious action
- With Covid-19 recovery and some central banks raising interest rates quickly, ‘carry’ trades that milk the rate differences between currencies are coming alive again
- Investors should also look out for divergence between policy directions and markets
Reading Time:4 minutes
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Of all major asset classes, currencies have the worst reputation. Unlike global stock and commodity indices, currencies generally do not appreciate, even if held for a long time. And unlike sovereign bonds, which promise a certain yield at maturity, currencies could produce negative returns even after a decade.
Since policy rates in the Group of 10 countries raced to near zero after 2008, and now to below zero for some since 2020, the lack of interest rate differentials among G10 currencies has made them even less attractive to investors than currencies in general.
Not too long ago though, before the 2008-2009 global financial crisis, macro fund managers touted their foreign exchange returns based on something called the “carry”. This involves milking the difference between the interest rates of two currencies in an investment that is often leveraged – meaning the trader is using his trading margin to cover only a fraction of the actual currency total – and ensures returns even when exchange rates dawdle.
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With a global recovery from Covid-19 taking shape, albeit unevenly, this G10 currency film is about to play again over the next several years.
G10 currencies tend to move at the beginning of economic and monetary policy cycles, given the hesitation from policymakers to tighten quickly. However, emerging market currencies may be buffeted by the large swings in capital flow that normally accompany a US Federal Reserve monetary tightening cycle.
The Reserve Bank of New Zealand and the Norges Bank of Norway could raise their interest rates twice this year, especially given their edge in tempering Covid-19 and their export gains from elevated commodity prices.
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