Volatility, Carry, Risk, and the Forex Markets

Upon reviewing my previous post on the Brazilian Real (BRL), I now realize that it lacked context. In other words, while both the interest rate outlook and economic prospects of Brazil are both incredibly bright, who’s to say that this hasn’t already been priced into the Real? At the very least, more information is needed to determine whether the Real is valued fairly on an historical and/or relative basis. [Alas, the focus of this post isn't on the Real specifically, but on the forex markets in general. Still, the concepts that will form the backbone of this post - volatility, risk, and carry - can be seen clearly through the prism of the Real.]

This doubt was sparked by an article that I read recently, entitled “Markets ‘Not Pricing’ Potential Risks,” which explored the idea that the renewed appetite for risk and consequent run-up in asset prices and re-allocation of capital is naively optimistic: ” ‘The unique environment we’re in now revolves around unprecedented level of government involvement in markets, which creates this complacency over risk because of this belief that governments will fix everything.’ Markets are under-pricing the risk that nations such as Dubai and Greece may default, and excess borrowing by others could lead to inflation.” From a financial standpoint, the practical implications of this idea is that the markets are underpricing risk.

In forex markets, complacency towards risk has manifested itself in the form of decreasing volatility. When you look at the 435 most commonly-traded currency pairs (actually most currency pairs involving the 35 most popular currencies), volatility is increasing for only nine of them. In addition, one month-volatility is now below 15% for all (widely-traded) currency pairs, which means that based on the most recent data, the highest, annualized standard deviation percentage change for every currency pair is only 15%. [It's difficult to translate that concept into plain-English, but the basic idea is that all currencies are (actually, only 68% of the time) currently fluctuating by less than 15% from the mean on an annualized basis. The idea of standard deviation is murky for non-mathematicians, so it's probably more useful to look at it on a relative and historical basis, rather than in absolute terms. In other words, the 15% figure can not be explained very well in an of itself; one must see how it compares to other currency pairs and to other time periods].

The fact that volatility is currently low suggests that the carry trade, for example, is set to become increasingly viable, especially when you factor in upcoming interest rate hikes. On the other hand, real interest rate differentials are currently modest (from a historical standpoint), and the concern is that rate hikes could be accompanied by rising volatility. The Brazilian Real, for example, “has a risk-adjusted carry of 45 percent, based on Morgan Stanley estimates, which means its carry rates had been better than current levels 55 percent of the time the last five years.” When you look at conditions from a few years ago, when volatility was at record low levels and interest rate differentials were larger than historically average, it’s obvious that the hey-day for the carry trade was in the past. It may come again in the future, but it certainly isn’t now.

From a practical standpoint, if you’re thinking about getting involved in the carry trade, you’ll want to choose a currency pair where the real (after adjusting for inflation) interest rate differential is high and volatility is low. You can cross-reference interest differentials with these charts – which uses recent mean return and volatility as the basis for forecasting confidence intervals – to get an idea about which pairs offer the best value (i.e. higher rate differentials at lower volatility). Just be aware that a sudden upswing in volatility could put a big dent in your risk-adjusted returns.

Brazilian Real Recovers on Rate Hike Hopes

One of the main themes (even if not always overt) of my posts recently has been the revival of the carry trade, if not the already extant revival than at least the imminent one. In this context, there is no better candidate than the Brazilian Real.

After a stellar 2009, the Brazilian Real opened 2010 in much the same way that most emerging market currencies did: down. In the month of January, alone, it fell almost 10% against the Dollar, as fears of a widespread sovereign debt crisis took hold in currency markets. Its modest recovery since then, is not so much due to a decreased likelihood of such a debt crisis, but rather to a shift in the markets’ perspective away from long-term fiscal problems and back towards short-term economic and monetary conditions.

It is here where Brazil (and the Real) shines. As one analyst summarized, “The Brazilian economy has been transformed over the past few years. The boom-and-bust and hyperinflation of previous decades has been replaced by steady growth. The country was one of the last major economies into recession, but one of the first out.” 2009 Q4 GDP came in at 4.3% on a year-over-year basis, and is projected at 6% for 2010. Moreover, its economy is very well-balanced, and consumer debt levels are relatively low. Unlike in China, for example, infrastructure investment in Brazil still has plenty of room to grow, without crowding out private investment. This is important, given that the 2014 World Cup and 2016 Olympics are right around the corner.

After rebounding from the lows of the 1999 currency crisis, meanwhile, the Brazilian stock market has had an incredible decade, returning an average of 20% annually. For the sake of comparison, consider that emerging markets have averaged 10%, and all stock markets have averaged only .2%. It doesn’t hurt that Brazil just discovered a huge (the fifth largest in the world) coastal oil reserve.

In fact, it might just be the latter that currency traders are most excited about: “Thus far this year, BRL is 68% correlated with crude oil prices…Last year the correlation was 53% and in 2008 the correlation was just shy of 32%.” This is the highest among any currency, even those that derive a much larger portion of GDP from oil exports, such as Canada and Norway. While there are almost certainly lurking variables in this correlation, a continued rise in the price of oil can’t hurt the Real.

Where does the carry trade fit into this? Look no further then Brazil’s benchmark interest rate of 8.5%. Impossibly, this represents a record low, despite the fact that this is nearly 8.5% higher than the current Federal Funds Rate. And the Brazilian rate is only set to rise. At the last meeting of the Bank of Brazil, 3 out of 8 Board members voted to hike the Selic rate by 50 basis points. The main opposition came from the Bank’s President, Henrique Meirelles, who steered a dovish course for political reasons.

Since then, inflation has continued to creep up and Mr. Meirelles has firmly renounced his political ambitions, and the stage is now set for a 75 basis point hike at the next meeting, to be held on April 28. Most analysts are projecting an “increase of between 200 and 300 basis points through mid-2011, [and] some investors are pricing about 450 basis points of hikes in the same period.”

It’s hard to predict if/when the Fed will follow suit, but most certainly won’t be to the same extent. As long as Brazilian interest rates can keep up with inflation, then, it looks like the Real will end 2010 in much the same fashion as 2009.