FX quarterly: Momentum and Carry have re-emerged as drivers of currency returns | Insight Investment

The resurgence of momentum and carry as drivers of currency returns is interesting as both factors lagged significantly in the post global financial crisis (GFC) world of zero interest rates. One of the key questions facing investors is if this trend is likely to fade or if the improvement is more structural. While momentum and carry strategies have performed well and some pullback in their performance is certainly possible, our sense is that their revival is more structural and is tied to the return to a more "normal" environment of higher and more volatile interest rates.

In the case of carry, the improvement in performance is likely to be tied to the rise in the spread between lower and yielding currencies – this spread currently stands at the highest level since the GFC (see Figure 1).

Figure 1: Max yield differential in DM currencies

Source: Insight, Data from January 1992 to June 2023

For momentum, the story is different, and the improved performance is likely to be linked to the higher level of interest rate volatility. As shown in Figures 2, almost all positive performance in our Momentum factor occurs when interest rate volatility is above a minimum threshold.

Figure 2: Annualized yield volatility

Source: Insight, Data from January 1992 to June 2023

If the current level of interest rate divergence lasts, we believe carry strategies are likely to continue to perform. On the other hand, if the volatility in interest rates subside and central banks maintain the current ‘higher for longer’ mantra, momentum strategies might have a harder time. Against this backdrop, we believe that a well-diversified set of currency drivers, rather than single factor strategy, will put active currency investors in the best position to take advantage of evolving market conditions.

Beyond the rise of momentum and carry, something else stands out as being interesting about 2023, namely the fact that the strong performance of the Carry and Momentum factors has happened alongside strong performance by the Volatility factor.

The three-pronged driver of currency behavior being carry, momentum and volatility is highly unusual. The last six months is the first time this combination of drivers has occurred in our entire dataset dating back to 1992. It makes for a challenging environment for traditional currency management. This is likely to be linked with the higher degree of economic and broader market volatility and highlights how strategies that are predominantly mean reverting in nature can perform along with others that are momentum driven.