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Don't kiss the carry trade good-bye

  • ECB to continue the normalization process based on the sentiment in financial markets
  • Government bond yields will rise to slightly higher levels by the end of the year

Carry trades - investing in high yield currencies funded by loans in low yield currencies - were among the most popular trading strategies in the course of the last few years. While carry trade strategies still succeeded in decoupling from the weakness in other risky asset classes well into July and posted new all-time highs, a massive setback emerged over the last few trading sessions. Over the medium term, Michael Rottmann, global head of FX and FI Research at UniCredit, expects a revival of carry trades. Since there will be no clear shift in yield differentials, but currency volatility will decline in line with the global risk aversion, investor appetite for high-yielding currencies will return.

According to Rottmann, carry trades were not the catalyst of the current financial crisis, they were merely the last domino to fall. In any case, currency strategies have continued to generate the highest returns since the beginning of the year compared to other asset classes. In the short term, further losses by the high yielding currencies and further strengthening of the low-yielding currencies are probable.

At the end of the year, UniCredit expects EUR-JPY to trade at 161. EUR-USD and EUR-CHF will probably be trading at a level of 1.33 and 1.63, respectively.

Central banks ride to the rescue: Volatility is more important than risk premiums
The cut of the US discount rate from 6.25% to 5.75% has demonstrated that financial market volatility is more important to the US central bank than the need for the higher risk premiums which central banks mentioned not too long ago. Whether the US central bank finally cuts the Fed funds target rate depends on the reaction in financial markets until the next FOMC meeting on September 18.

Renewed selling pressure would – similar to 1998 – lead to monetary easing. To be sure, the Fed is not too happy easing monetary policy as this will in the end lead to a new round of the "moral hazard" discussion, i.e. the Fed bails out highly leveraged market participants again, a situation that over the past 10 years always resulted in an extreme risk appetite and the problems we now face. However, as financial markets are extremely closely linked to economic momentum, there are no other options left for the central bank.

Also the environment concerning monetary policy in the ECB changed. If the action by the Fed was enough to stabilize financial markets quickly, another rate hike by 25 basis points is likely in September. In contrast, if financial markets stay shaky, a delay of further monetary tightening is a sure bet.

The inflation environment is also neutral
Inflation is still not an issue. Dominated by the persisting positive impulses from globalization, inflation in the Eurozone has already been exactly in line with the ECB mandate of just under 2% for nine months now. For 2008, we see only a slight uptick to an average level of 2.1%.

The core rate will probably rise to around 2%. The situation also remains manageable in the US. Even though the deflator of personal consumption expenditures will rise slightly above the imaginary target corridor of 1-2%, this is, however, unlikely to trigger changes in monetary policy.

Only a slight uptick in bond yields
However, money market forwards are clearly exaggerated right now. Forwards in the US price in 100 bp of easing until mid-2008. In Euroland, no further rate hike is priced in until mid-2008. As soon as these overly aggressive expectations are revised, yields at the long end of the curves will increase slightly.

10Y US Treasuries are expected to end the year around 5% and the 10Y Austrian government bond yield have room to increase towards 4.5/4.6%.

In the fixed income segment, the money market remains the top priority for investors because of the still flat or even slightly inverse yield curve. We still think funding in JPY is too risky, despite the much firmer JPY.

Contact: Veronika Fischer-Rief
UniCredit Markets & Investment Banking, PR Office
Tel. +43 50505-82833,
E-mail: veronika.fischer-rief@ba-ca.com


This document does not constitute an offer to issue or sell, or the solicitation of an offer to acquire or buy any securities to any person in any jurisdiction.

In the United Kingdom, this announcement is directed exclusively at persons who have professional experience in matters relating to investments who fall within Article 19 or 49 of the Financial Services and Markets Act 2000 (Financial Promotion) Order 2001. In the United Kingdom, the securities will only be issued to such persons.

This press release is not an offer of securities for sale in the United States.  The securities  referred to herein have not been and will not be registered under the United States Securities Act of 1933 (the "Securities Act") and may not be offered or sold in the United States absent registration under the Securities Act or an exemption from registration. There will be no public offer of the bonds or the shares referred to herein in the United States.