The End of the Fed’s QE and its Impact on Markets: Part 2

This is the final of two posts on the impact of the end of the Federal Reserve’s quantitative easing (QE) program on markets, and it will focus on the impact on the “carry trade,” of which the New Zealand Dollar is considered. We will examine the outcomes for a reduction in QE3 and how it might impact FX markets.

The end of the Federal Reserve’s QE3 program may be approaching fast. Market participants have become increasingly anxious as to the next direction the world’s most influential central bank will take as it measures the health of the U.S. economy.

In the previous post, we examined how speculation over the Fed’s QE3 “taper” has caused clear misalignment in two key markets: bonds and stocks. This agitation has spread across the globe and has helped provoke the early stages of a Southeast Asia/emerging markets crisis  (covered in future postings), which has done nothing short but wreak havoc on assets deemed “risky.” Similarly, the “carry trade” has suffered as a “risky asset.”

What exactly is the carry trade? Investopedia defines it as:

“A strategy in which an investor sells a certain currency with a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate. A trader using this strategy attempts to capture the difference between the rates, which can often be substantial, depending on the amount of leverage used.”

Returns from carry trade strategies were serial outperformers for over three decades before the global financial crisis of 2008. Data from 1971 to 2005 illustrates this point clearly enough:

Article 2 Table

Not only did the highest yielding currency basket in this case study offer the highest average annual return over this time series, but by theoretically going long basket 6 – the highest yielding basket – while shorting basket 1 – the lowest yielding basket – investors would take in an annual return of 4.35%. Risk is compensated, too: the Long 6/Short 1 basket has the highest Sharpe Ratio among the seven samples.

The carry trade hasn’t been so kind this year. A typical carry pair in the wake of the global financial crisis – the NZDUSD – hasn’t produced the kinds of returns risk-seeking investors would have hoped for. And that’s simply because of the chatter around the Fed’s tapering of QE3. The New Zealand Dollar, as the highest yielding major currency (the Reserve Bank of New Zealand maintains a key rate of 2.50%, the same as the Reserve Bank of Australia now) and member of the commodity bloc, finds itself in the crosses.

It’s clear that concerns about the Fed winding down QE3 has been bad news for the New Zealand Dollar and the carry trade. After peaking above $0.8600 in April, the NZDUSD slid to as low as $0.7727 (on a closing basis) in late-August –  greater than a -10% drop in just over one quarter.

Article 2 Graph

Why has this type of volatility returned? Higher U.S. yields have reduced the interest rate differential between the New Zealand and U.S. Dollars, and considering that once the Fed begins to exit it will be difficult for it to turn back, we can surmise that this instance of the carry trade – the NZDUSD – will struggle to find meaningful direction going forward. At this point, the only hope for any U.S. Dollar-funded carry trades is for a turn lower in U.S. Treasuries yields, and that might not happen if the U.S. economy improves and the Fed proceeds with tapering QE3.