We are starting to see a glimmer of the return to carry in the foreign exchange market with the Federal Reserve now on the taper path. We even have seen the first rate hike amongst the developed world’s central banks as the Reserve Bank of New Zealand lifted rates. This is an important turning point for the global financial markets, but it is particularly critical for currencies. Yield establishes a hierarchy for global capital flows while also engendering greater volatility by fostering competition and simultaneously draining support built up through moral hazard.
The road out of the deep stimulus trenches will be a long one, but the early moves are often the most lucrative. Establishing who is leading and lagging in this race will be a key assessment of currency performance moving forward. At the same time, these changes could also provoke turmoil in a delicately balanced backdrop of speculative positioning.
We have seen equities charge to record levels, tepid carry trades leveraged to multi-year highs and high-quality bonds swapped out for their high yielding counterparts. With rates of return (interest, dividends, yield) having collapsed in the wake of the financial crisis, market participants have had to take on greater risk to generate returns on par with—much less better than—benchmarks like the S&P 500 (CME:ESM14). This has led to years of stockpiling risky exposure and building leverage to unseen heights. “Nowhere else to go,” (below), shows the gearing that has set the foundation underneath the remarkable performance.