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Don't Get Carried Away by Carry Trades

Caution
Caution

Talk of carry trades is in the air again. Best not to get drawn in, these strategists say.

Tired of all the euro zone drama? Really, who isn't? It's tempting, these days, to think instead about good old fashioned carry trades - buying high yielding currencies and selling low yielders, and pocketing the difference.

Right now, the euro is looking like an especially attractive funding currency, what with euro zone interest rates low, the economy weak, and the ongoing crisis.

Don't go there, say the strategists at RBC Capital Markets.

Interest rates are low in many countries, not just in the euro zone, and that limits the potential for a carry trade to be profitable, they say. Also, although volatility has declined recently, it is still high enough that there is a real chance a carry trade will be a dud - especially with the compression in interest rate differences.

"The decline in volatility does not even come close to compensating for the compression of yield spreads," the strategists wrote in a note to clients. They estimate that volatility would have to fall to around three percent, from about nine percent currently, to get many investors interested in carry trades. "As such the carry-to-risk ratio – a good barometer of the efficacy of carry as an investment strategy – is still far below its historical average."

Still interested in carry trades despite these warnings? If so, the RBC strategists have done some legwork for you and figured out which currencies offer the most potential as funding currencies - that is, currencies to be sold against higher-yielding ones. According to the RBC analysis, while euro zone interest rates have fallen, the euro is only the second most promising funding currency for a carry trade. Top honors go to the Canadian dollar, particularly when it is sold against commodity-linked currencies like the Mexican peso or the Australian dollar.

Don't say they didn't warn you.

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