The return of the carry trade is negative for the US dollar... The flow of investors seeking to swap zero-yielding dollars into higher-yielding currencies and/or risk assets is only likely to be halted by a rise in US interest rates. On that basis, we would not expect to see the US dollar strengthen until the second half of 2010 at the earliest. That said, investors may reverse their positions ahead of this time, either in anticipation of the rate hike, or as a consequence of negative developments for the foreign currency assets they are holding. The reversal of this carry trade is likely to be a significant trend, given the size of the position that will have been built up, suggesting that the US dollar could well swing from oversold to overbought territory.
...providing a number of short-term winners. The beneficiaries of the carry trade are widespread. The three key winning themes for currencies appear to be high-yielding, commodities and emerging markets. This explains why some currencies - such as the Brazilian real, which combines all three themes - have been such strong performers.
Yet not all currencies currently appreciating against the dollar are equally vulnerable. We favour emerging Asian currencies for the longer term as a result of positive trade balances, strong government finances, and the scope to increase interest rates as recovery takes hold. However, we recognise that continuing concern about the sustainability of the recovery means that no government is likely to welcome currency appreciation (and the precedents for intervention are now clearly established, even if governments' ability to do more than slow currency appreciation is limited).
Interest rates could be low for even longer. We have already seen the first rate hike, in Australia - a country that did not suffer a technical recession during the global crisis. However, this has little bearing on those countries which have experienced one of the worst recessions of the past 60 years. For these countries, rate hikes may come even later than currently anticipated, with fiscal tightening taking priority. Quantitative easing has reduced in significance and initial signs are that its reversal will not be a significant event, though many countries are not yet in a position to contemplate such action.
