By Anirban Nag
LONDON (Reuters) - Investors wrong-footed by the Federal Reserve's decision to keep its stimulus programme unchanged have a chance to boost their bottom line by using cheap dollars, euros and yen to buy higher-yielding currencies.
The return of such trades is expected to revive volumes in a foreign exchange market that has seen business decline in recent months as investors bought and held dollars in anticipation of a rise in value as the Fed slowed the pace of its money-printing.
Average daily trading volumes shrank to $4.5 trillion (2.8 trillion pounds) in August, below a record high of $5.6 trillion in June, according to CLS Bank.
But with the U.S. central bank's $85 billion-a-month bond-buying programme intact, the dollar should grind lower in coming weeks. As Bank of Japan has pledged to flood markets with cash and the European Central Bank is ready to do the same, the euro and yen are also set to struggle.
Investors seeking to boost their returns are likely to buy growth-linked, higher-yielding New Zealand, Australian and Canadian dollars on growing evidence of a global economic recovery. Sweden's and Norway's crowns should also benefit.
Such "carry" trades - in which an investor borrows in a cheap currency to buy a riskier higher-yielding one - were popular last year and early this year when the Fed's and the BoJ's money printing fuelled a rally in riskier assets worldwide.
Analysts say the revived trade may not be around long, as the Fed will eventually withdraw stimulus. But until then, it could provide a final-quarter fillip for hedge funds and banks.
Given the uncertainty about Fed policy, some banks are warning of lower revenues in the third quarter from fixed income, currencies and commodities trading.
"Volumes could increase to some extent. Lots of investors would have made losses due to the Fed's decision, so they would want to recover that before the year end," said Kiran Kowshik, strategist at BNP Paribas.
"Our economist expects tapering by the Fed not to start until March, so we could see U.S. yields ease and that could see a relief rally in the Australian and Canadian dollars."
U.S. yields have been rising since May and hit two-year highs earlier this month as expectations the Fed would slow its stimulus drew investors into dollar-denominated assets.
That marked a reversal from earlier in the year, when the cheap dollars pumped out by the Fed made their way to riskier emerging markets and higher-yielding growth-linked currencies.
KEEP CALM AND CARRY ON
With the Fed standing pat and dollar borrowing costs falling, currency trades funded in the dollar are likely to make a comeback. Even so, record foreign exchange volumes hit in June may not be repeated in the short term.
In a sign of what might be expected, yen-funded carry trades increased after the Bank of Japan unleashed its massive stimulus programme in April.
Yen-selling picked up and overall FX volumes rose to just above $5 trillion a day.
Carry trades have proved profitable. Selling low-yielding currencies in favour of higher-yielders has generated 5 percent annual returns to investors in the past three decades, according to a study by the Cass Business School released last year.
So it remains a favourite strategy for fleet-footed investors, speculators and banks looking to enhance returns.
But according to Nomura's cross-asset carry trade index, currency-related trades have underperformed since Fed chief Ben Bernanke first indicated in late May that the U.S. central bank could start tapering its $85 billion a month of asset purchases.
Nomura strategist Ankit Sahni said carry trades investing in the currencies of the Group of 10 big economies are still down 6 percent from their May peaks. In contrast, carry trades in high-yielding U.S. assets such as corporate bonds have retraced all their losses since May after the Fed surprised markets by not starting stimulus withdrawal this month.
The Fed's decision has also depressed implied volatility, a gauge of how choppy a currency will be. That suggests currencies are unlikely to see sharp sell-offs, creating a more conducive environment for leveraged carry trades.
Indeed, speculators halved short bets against the Australian dollar in the week to September 17 and turned positive on the New Zealand dollar.
"The message for now is clear: carry stays king, with dollar and yen acting as funding tools," said Hans Redeker, head of global FX strategy at Morgan Stanley.
(Editing by Nigel Stephenson and Catherine Evans)