Currency investing

Market practitioners often rely on experience-based wisdom to navigate currency markets, and one such widely held belief is that low dispersion in global bond yields signals weak future returns for carry trades (and high dispersion implies high future carry returns). While this intuition makes sense—when yield differentials are compressed, the incentive to exploit them diminishes—a recent academic study provides a solid theoretical foundation for this idea. The research not only confirms this observation with rigorous empirical analysis but also explains the underlying financial mechanisms that drive the relationship. By quantifying the effect and presenting clear visualizations, the study transforms an intuitive market rule of thumb into a well-grounded principle backed by data.

Our article explores a simple mean reversion trading strategy applied to FX futures, focusing on identifying undervalued and overvalued currencies to generate returns. Using FX futures rather than spot rates allows for the inclusion of interest rate differentials, simplifying the analysis. The strategy employs two position-sizing methods—linear and exponential—both rebalanced monthly based on currency deviations from their mean. While the linear method offers stability, its returns are limited. In contrast, the exponential method, despite higher risk and deeper drawdowns, ultimately delivers stronger growth and better overall performance by leveraging the mean reversion tendencies of FX pairs.