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Best Carry Trades Claudio Irigoyen Mai Doan MLPF&S MLI (UK) claudio.irigoyen@baml.com mai.doan@baml.com Rohit Garg Vadim laralov Merrill Lynch (Singapore) MLPF&S r.garg@baml.com vadim.iaralov@baml.com Carry trades and blond swans ¢ We do not expect traditional carry trades such as ARS and BRL to perform well ina strong USD and increasing interest rates environment, so we focus on USD neutral carry trades. ¢ We like short EUR/RUB, short SGD/INR and long PEN/CLP. For more neutral commodity exposure we like baskets of EUR, CAD, COP and CLP, AUD to fund RUB and PEN trades respectively. Carry is in the eye of the beholder To focus on identifying best carry trades in the current environment of rising US interest rates sounds counterintuitive at least. It is well know that carry trades perform nicely in risk-on periods as well as in a low volatility environment, which is the opposite of what we expect in the coming months. However, once proper factor exposure of currency returns is considered, smart carry reemerges as an interesting proposition. As we have documented (Forecasting with Compass30), most of the variation in currency returns can be explained by the first two principal components, which can be labeled as dollar and carry factor respectively, as they are highly correlated with USD and carry performance. Expected returns of carry strategies are defined by interest rate differentials (ie, carry), assuming no change in spot exchange rates. Uncovered interest parity states that the carry should be offset by a change in the spot of equal magnitude. However, empirical evidence (so called forward premium puzzle) clearly shows that carry trades are profitable on average, which indicates the presence of currency risk premium. Since both dollar and carry, are priced factors, any sensible carry strategy in an environment in which US rates are rising needs to hedge the USD exposure. This is just a necessary though not a sufficient condition, since the carry factor is also correlated with global measures of risk. Interestingly, post-election currency losses is not as highly correlated with carry, indicating that carry trades were not as a strong investment theme as it was the case during the taper tantrum episode (Chart 62). Chart 62: Carry didn’t drive currency reaction to US elections Chart 63: Asia and LatAm display the highest risk-adjusted carry 25 mw 1m carry (annualized) - 15 3 Currency depreciation since Nov8 (rhs) mw 1m carry (annualized) / 1m implied ATM vol @1m carry (annualized) / max 1m DD (5y, rhs) og B oa = o & 5 a = con) Pe] lobal Research, Bloomberg Source: BofA Merrill Lynch Global Research, Bloomberg BankofAmerica <2” 36 Global Rates, FX & EM 2017 Year Ahead | 16 November 2016 Merrill Lynch HOUSE_OVERSIGHT_014766