How News-Based Indicators Can Guide Carry Trade in Uncertain Times

July 8, 2024

We examine volatile GBP and EUR movements to showcase the effectiveness of RavenPack's FX Mean-Reverting Factors in optimizing carry trades.

FX markets are currently impacted by uncertainty around inflation and the monetary policies of developed countries, and the resulting volatility makes it harder to navigate the carry trade. The RavenPack FX Mean-Reverting Factors monitor extreme media coverage of currency-related events, which can help sharpen FX traders’ perspectives.

When leveraged to enhance the risk premia, these factors provide fast adjustments to benchmark weights. They signal overweights or underweights in the opposite direction of media attention, anticipating fast reversals in exchange rates. The Carry risk premium benefits from these signals by enabling fast, active bets independent of the current interest rate regime, adjusting exposure to capitalize on rapid currency movements or mitigate risk.

To test the efficacy of FX Mean-Reverting Factors in carry trade optimization, let’s take a look at two case studies examining the GBP and EUR during periods of heightened volatility.

Case study 1

British Pound Volatility in 2020, 2022 and 2024

A recent example of increased volatility involves the British Pound (GBP) in late April 2024. The release of March inflation data and expectations of further decreases coincided with GBP appreciations. However, expectations of interest rate cuts led to sharp depreciations, quickly followed by a rebound due to economic activity expansions and inflation uncertainty. Media coverage shifted rapidly, and the FX Mean-Reverting Factor recommended long positions, anticipating the reversal from April 22nd onwards.

Figure 1. Macroeconomic events (top-left) involving the British Pound in April 2024, currency-related events driving extreme media attention (top right), and their impact on the FX Mean-Reverting Factor (bottom). The bar charts report the volume of events by Event Category detected on the days of extreme media attention as depicted by our FX Mean-Reverting Factor, smoothed with Decay 4. The vertical dashed lines in the bottom charts indicate the days in which the FX Mean-Reverting Factor signaled extreme media attention. Source: RavenPack, June 2024.

October 2022: Bank of England Announcement Impact

Another episode occurred on October 12th, 2022, when the GBP weakened due to the Bank of England’s announcement to end support for pension funds and ambiguous communication regarding bond market interventions. Extensive media coverage led to a rapid decrease in the FX Mean-Reverting Factors. However, GBP rebounded the following day after supportive actions by the Bank of England. The FX Mean-Reverting Factor prompted an increased GBP allocation in the Carry portfolio, capitalizing on the currency's rapid recovery.

Figure 2. Macroeconomic events (top left) involving the British Pound in October 2022, currency-related events driving extreme media attention (top right), and their impact on the Carry risk premium enhancement (bottom). The bar charts report the volume of events by Event Category detected on the days of extreme media attention as depicted by our FX Mean-Reverting Factor, smoothed with Decay 4. The vertical dashed lines in the bottom charts indicates the days in which the FX Mean-Reverting Factor led to extreme tilts of the GBP. Source: RavenPack, June 2024.

2020 UK Economic Challenges

In 2020, negative interest rates and low economic activity in the UK also led to fluctuations in the British Pound. Media attention shifted rapidly between currency appreciations and depreciations. The FX Mean-Reverting Factor reached extreme negative values, which were followed by reversals. Leveraging this factor to enhance the Carry portfolio generated higher returns by accurately timing subsequent GBP appreciations.

Figure 3. Macroeconomic events (top left) involving the British Pound in 2020, currency-related events driving extreme media attention (top right), and their impact on the FX Mean-Reverting Factor and the Carry risk premium enhancement (bottom). The bar charts report the volume of events by Event Category detected on the days of extreme media attention as depicted by our FX Mean-Reverting Factor, smoothed with Decay 4. The vertical dashed lines in the bottom charts indicate the days in which the FX Mean-Reverting Factor led to extreme tilts of the GBP. Source: RavenPack, June 2024.
Case study 2

Euro Fluctuations Amidst Monetary Policy Speculation

In May and June 2022, the Euro faced significant market attention due to reports of rising inflation and the anticipation of interest rate hikes. This period saw a dominant narrative surrounding the macroeconomic landscape, particularly in the first week of June.

Figure 4 provides a detailed illustration of these dynamics. The top left panel depicts how these reports influenced the Euro's behavior, leading to appreciation on June 5th and 6th. This upward trend was fueled by expectations of further currency appreciation, evident from the numerous detections of currency-related events such as appreciations and future anticipated appreciations, represented by light green and orange bars, respectively.

However, this surge in positive sentiment created an abnormal coverage of currency-related events, triggering a positive FX Mean-Reverting signal. Consequently, the Euro was overweight in the short leg of the portfolio, anticipating imminent depreciations.

Shortly after June 9th, the European Central Bank's announcement of interest rate increases prompted doubts about the Eurozone economy and its currency's strength. This led to a rapid reversal in sentiment. Despite the initial appreciation, the Euro experienced depreciation following the ECB's announcement.

The overweight allocation in the short leg of the portfolio, guided by FX Mean-Reverting Factors, played a crucial role in significantly boosting returns attributed to the Euro.

Figure 4. Macroeconomic events (top left) involving the Euro in June 2022, currency-related events driving extreme media attention (top right), and their impact on the Carry risk premium enhancement (bottom). The bar charts report the volume of events by Event Category detected on the days of extreme media attention as depicted by our FX Mean-Reverting Factor, smoothed with Decay 4. The vertical dashed lines in the bottom charts indicate the days in which the FX Mean-Reverting Factor led to extreme tilts of the EUR. Source: RavenPack, June 2024.

Coming soon

Our upcoming paper on currency risk premia enhancements using RavenPack FX Sentiment will explore additional episodes and the impact of macroeconomic events on currency fluctuations and risk premia.



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