On most recent rate cut (It's a surprise to have a surprise)

Each time the FED raises or cuts the policy rate, it is printed on the front page of major news outlets. However, it is rarely breaking news itself. By design, the FOMC makes sure to give the market enough transparency and hints, so the cut is largely anticipated ahead of time.

The consensus in the US is usually strong enough to make even ChatGPT hallucinate in the past tense when enquired about an upcoming rate cut.

However, when it comes to other countries, transparency is less of a norm, and sometimes the policy change catches the market by surprise. This is often true, for example, of Central European currencies or South Africa.

There are dedicated services such as CME's FedWatch that estimate decision probabilities. The simple framework that works best for me is to look into spreads between the current RFR and forward-looking swap rates for various tenors (Fig 1). I like this approach because it is simple, can be applied universally to any currency (not just USD), and doesn't depend on proprietary probability models.

The attached example shows that on Wednesday, 29th October, just hours prior to the FED announcement, the SOFR fixing to the 2W SOFR IRS was -34 bp, fairly high by this year's standards.

It is worth noting that this methodology combines the magnitude and certainty of a rate jump into a single number. Looking into swap tenors longer than 1M encapsulates the effect of multiple rate announcement.

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⚠️ Personal opinions only, no investment advice or product solicitation.

On FX Carry (Part 2)

Previously, we explored basic mechanics of FX carry trades and reasons behind the existence of the risk premiums. Carry trades in managed currencies can be profitable, yet inherently very risky (think of fat-tail events).

In this post, we will use a carry/vol framework to assess viability of carry trades in G20 currencies (see attached table). We are looking for currencies that exhibit high IR differential with a low probability of adverse FX movements. This probability can be analyzed in multiple ways:

1️⃣ Historical and Implied FX Volatility

Historical FX volatility is a go-to measure for assessing the risk of adverse currency movement. The drawback is that it is backward-looking and not well suited for pegged/managed currencies or currencies with large spot/vol correlations (which are typical for emerging markets). An alternative measure is volatility implied from FX options, because incorporates forward-looking market consensus.

2️⃣ Risk Reversals

Positive risk reversals indicate that currency is likely to experience high volatility, if it depreciates. Risk reversals tend to be higher for currencies with asymmetric, event-driven, or political risks. This applies to both managed and free-floating currencies.

🟥Managed Currencies

Pegged (AED, SAR, HKD) or managed (TWD, CNY, SGD, MYR, INR, and to some extent also JPY) currencies typically offer lower volatility when measured using historical data or implied from ATM option volatilities. This can sometimes mislead traders into a false sense of security when executing carry trades.

It is not a coincidence that most recent headlines were made in managed currencies such as JPY and TWD.

(See graph showing managed currencies in red and free-floating in green)

🟩Free-Floating Currencies

Free-floating currencies such as GBP, AUD, or EUR offer less potential for profitable carry trades, since their central banks manage interest rates in a fashion resembling synchronized swimming, leaving their FX movements to market forces. On a flip side, these currencies exhibit less tail risk.

🧨FX Carry and Political Risk

While currencies like the Turkish lira (TRY), Russian ruble (RUB), and Brazilian real (BRL) may initially appear attractive for carry trades, they carry significant political risk that can undermine their appeal. In particular, the TRY is prone to persistent depreciation, driven by the country's high inflation environment. As a result, purchasing power parity considerations are essential when forecasting its future trajectory.

Attached figure shows evolution of TRY between Oct 2024 and Oct 2025. The actual depreciation is around 20% due to inflation, while the interest rate differential is above 30%.

It is worth noting that the resulting 10% premium exists for a good reason - FX returns are not normally distributed, and there is significant fat-tail risk due to political events. For example, consider the 19/3/2025 arrest of Istanbul's Mayor E. İmamoğlu, which resulted in a 5% drop in value within a single day.

⚠️Disclaimer: This is personal post, no investment advice. Please read full disclaimer in the footer.

On FX Carry

Carry strategies are as old as the markets themselves, and almost everyone at some point has come up with the idea of "borrowing low and investing high".

Macro hedge funds love this idea too, mostly because of its ability to deliver solid market-neutral returns with low Beta and vol. The drawback comes with the tail risks, and the main skill in running this strategy lies in the ability to avoid and manage catastrophic events. More on that later.

💡The idea is simple:

- Borrow money in a low-interest rate currency
- Invest in a high-interest rate currency
- Profit from the interest rate differential
- Avoid periods of high volatility and regime changes

🌐Risk-neutral and risky worlds

In the risk-neutral "Q" world, expected future FX rates are equal to today's FX forward rates. Therefore, one is expected to earn a risk-free rate with no risk simply by means of the covered interest rate parity - buying FX spots and selling FX forwards.

However, we are not living in a risk-neutral world. By not covering the risk exposure, one enters the real world of risk and the "P" pricing. In this world, FX rates follow paths prescribed by trade balance, NIIP and other macroeconomic relationships.

FX risk is the reason why people are willing to flock into low-interest rate currencies (the risk buyers) and why others are willing to exploit the rate differential by engaging in the carry trades (the risk sellers).

💵 Taiwanese Dollar Example

For example, consider USD/TWD chart between May 2024 and May 2025. Quarterly deposits on USD were trading in range of 450-500 bp, while Taiwanese were lingering around 160-170 bp.

For Taiwanese investors (mostly life insurance companies), it was far too attractive to miss the opportunity to convert TWD into USD and invest in a high-yielding currency abroad rather than at home.

Red line (🟥) shows the term structure of USD/TWD FX forwards as of May 2024, predicting the currency path in a "risk-neutral" world (Q), where market risk is not priced in. In such a world, one would expect to buy USD at 32.474 and sell it one year later at 31.166, realizing an FX loss on USD, offset by its higher deposit rate.

However, that's not what happened in the "real world" (P). Thanks to the Taiwanese semiconductor industry and a positive trade balance with the US, the Taiwanese dollar enjoyed levels indicated by the blue line (🟦), above and beyond what was "deserved" by the interest rate differential.

Surplus on Taiwanese capital account was offset by deficit on investment account, thanks to all the lifers allocating capital to US Treasuries. This created tension in the investment position, which ultimately snapped in May 2025, resulting in a rapid unwinding of carry trades.

Another example is the JPY carry trade, which began in the early 1990s when the Bank of Japan slashed interest rates amid concerns over long-term economic growth. This strategy has remained popular ever since, though it occasionally backfires. Most recently, it made headlines in August 2024 when the Japanese yen experienced significant strengtening.

And that's the moral of today's story - those who are attracted by superior risk-adjusted returns on carry trades must be prepared for hidden fat-tail risks.