Abstain from Overstepping Boundaries

The British Pound Sterling has emerged as the highest-yielding G10 currency in 2025, appreciating nearly 8% against the US Dollar. This has made it a leading candidate for carry trades, a financial strategy that involves borrowing money at a low interest rate and depositing it in an asset with a higher yield.

However, the higher yielding currencies are currently more expensive, meaning that the carry trade effectively requires investors to bet against reversion. In this current environment, the carry trade favours currencies like the New Zealand, U.S., and Canadian dollars, which aren't cheap.

The carry trade seems to be in a lower yield, higher risk environment where it is positioned against the underlying fundamentals of the currencies that it favours. Purchasing power parity (PPP), a method used to measure fair value of currencies, favours currencies like the yen, the euro, and the pound sterling.

Yield spreads are extremely low, with the 25th percentile being the current norm. Despite the huge valuation opportunities available, the potential gains from yield pickup are still quite small.

Currency valuation spreads are at all-time extremes and yield spreads remain quite small. This suggests that the size of the yield pickup in the carry trade has recently increased but is still historically small.

The DB G10 Currency Future Harvest Index, an index created to track the performance of the carry trade using G10 currencies, takes long positions in the three highest yielding currencies and short positions in the three lowest yielding currencies with a 2:1 leverage ratio.

The recent changes in rates have prompted a sudden resurgence in carry performance. However, it's important to note that carry trades don't always work, particularly when trading against the fundamentals.

Value spreads in currencies should also be considered, given that the size of yield spreads seems to be an important factor in the performance of carry. The current value model shows the Japanese yen, euro, and the pound sterling as 41%, 30%, and 21% undervalued, respectively, according to the SGM valuation models.

Despite the historical performance of the DB G10 Currency Future Harvest Index having been somewhat poor over the last 15 years, the temptation is to over allocate to carry. However, our analysis suggests that now is not the time to get carried away.

The views expressed are those of the GMO Systematic Global Macro team and are subject to change based on market and other conditions. It's always crucial for investors to conduct their own due diligence before making any investment decisions.