Markets Views | The biggest risk from the dollar’s drop may not be what you would guess

A high-risk corner of the USD5.1 trillion-a-day currency market has become the collateral damage of the dollar selloff.

Whipsawed by the greenback and confronted by U.S. policy confusion, carry trades were supposed to be a rare bright spot for investors who want to stay away from the world’s biggest reserve currency. Under the strategy, you borrow in low-rate alternatives such as the yen, and buy high-yielding peers like the Mexican peso, benefiting from low volatility and the emerging-market rally.

Practitioners of the carry trade are learning there’s no hiding from the dollar’s influence. Growing doubts about the outlook for U.S. policy following the failed attempt at health-care reform not only led to a weaker dollar, it also caused investors to pile into havens such as the yen and the euro – the funding currencies carry traders sell as part of the strategy. The Japanese currency gained 2.2 percent against the dollar this month, while the euro rose 2.7 percent.

“The carry trade is far more important than the dollar move in the changing the currency market,” said Bob Savage, chief executive officer of hedge fund CCTrack Solutions LLC in New York. “The rise in the yen may actually put the trade at risk. The dollar itself doesn’t affect the biggest FX trade out there, but the yen does.”

There’s no hard evidence available in analyzing the scale of carry trades. But according to Bank of America Corp.’s flow data, buying emerging-market currencies made up the biggest long position as of last week. The data blend positioning and sentiment surveys conducted with its hedge fund and real-money clients, and publicly available futures data.

Nonetheless, carry traders could still make a profit because of yield differentials or appreciation in emerging-market currencies. At a time when most investors have capitulated on the strong-dollar bet and currency funds struggle to yield any return for yet another year, the carry strategy may be the last oasis.

In fact, the trade is still worth it even though the funding leg of the trade goes south, according to Societe Generale SA, and investors should buy currencies such as Russia’s ruble, the Turkish lira or India’s rupee against the euro.

“High yielding currencies should outperform a basket of low yielders over the near term,” Guy Stear, head of emerging markets and credit research at Societe Generale, wrote in a note published March 24. “Global markets remain enamored of risk and emerging markets have been no exception.” Andrea Wong, Bloomberg