Top carry trade gets squeezed by Taiwan dollar’s advance

The Taiwan dollar is the world’s cheapest-funding currency for carry trades, beating out favorites like the euro and the yen and attracting recommendations from Goldman Sachs Group Inc. and BNP Paribas SA. Just watch out for that relentless appreciation.

The currency boasts of an implied yield at least five times more negative than the yen and the euro, making it attractive for carry plays that typically see investors borrow in low-yielding currencies to invest in higher-yielding assets. The catch though is that there are a limited number of trades—such as against the yuan—given forecasts for the Taiwan dollar to extend three quarters of gains.

With global bond yields still recovering from pandemic-induced lows, investors are on the hunt to squeeze more returns—which makes the Taiwan dollar an attractive, if risky, proposition as a funding currency. Analysts from Bank of America Corp. to Natixis SA see the currency getting boosted on demand for its tech exports, which would then erode gains from carry trades.

“We recommend long CNH/TWD as our top carry trade,” said Sid Mathur, head of Asia Pacific emerging markets research at BNP Paribas, while warning that a strong cyclical recovery in semiconductors could reduce the Taiwan dollar’s funding advantage against other currencies.

Buying offshore yuan with Taiwan’s currency is expected to work because both economies are rebounding quickly from the pandemic, and both are big tech exporters—meaning their currencies may have less divergence. Taiwan’s central bank also has a strong incentive to cap currency gains to keep chip exports competitive, Mathur said.

The Taiwan dollar enjoys a funding advantage of at least three percentage points below the euro and the yen, according to data compiled by Bloomberg.

That’s because hedging by Taiwan’s life insurers for their overseas assets—where they sell the dollar against the local currency using non-deliverable forwards—drive its implied yields lower, according to Stephen Chiu, Asia foreign-exchange and rates strategist at Bloomberg Intelligence.

Pairing the Taiwan dollar with a currency with a higher yield and lower volatility such as the offshore yuan will result in a significantly higher carry than using the dollar for funding, Goldman Sachs strategists including Kamakshya Trivedi wrote in a note last month.

Performance Pressure

The Taiwan dollar is Asia’s best-performer this year, rising 0.5%. The offshore yuan is its nearest competitor, and this week erased all its gains for 2021 after a stronger dollar and higher Treasury yields eroded the advantage of a strong Chinese economy.

Throw in an implied yield of 0.71% for the Chinese currency, and an investor could pocket a return of 1.6% from the trade in three months, should both stay at current levels.

The Taiwan dollar traded at 28.364 per dollar on Tuesday, near its strongest level since 1997. Bank of America sees it at 26.9 per dollar by year-end, while Natixis expects at 27.3 per dollar.

“The Taiwan dollar has solid fundamental reasons to appreciate further with its stellar export performance, which means Taiwan will continue to be a magnet for direct and portfolio investment inflows driven by semiconductor-led industries,” Natixis economist Gary Ng said.