According to currency strategists at Deutsche Bank, this creates an opportunity for the same kinds of convergence trades that preceded European currency union û as countries move towards adopting a single currency unit, and therefore common interest-rate policy, investors can profit from betting that today's differences in yield will erode over time.
This tendency is driven by an increasing focus among Asian economies to tie their currencies to trade-weighted baskets in the hope of keeping their exports cheap. Four of the region's currencies are already officially pegged to such baskets, and others are tacitly trade-weighted.
Since 2005, China, Indonesia, Korea, Malaysia, the Philippines, Singapore and Thailand have maintained their currencies at levels that are very close to full monetary union û trading, in effect, as a single block. This makes a lot of sense. Intra-regional exports are growing relative to exports to the US and Europe, and account for more than half of all Asian goods and services sold abroad.
At the same time, a network of free trade agreements is laying the foundation for a common market. Currency union may be the next logical step. The Asian Development Bank, as well as several academics, support an Asian currency unit and an Asean+3 group is already exploring the idea.
"If you look at Asia today, the economic case for monetary union is about as strong as it was in Europe at the time of the Maastricht treaty," says Martin Hohensee, Deutsche's head of fixed income and credit research, referring to the agreement signed in 1992 that created the EU and paved the way to the adoption of the euro.
Deutsche's solution for taking advantage this time around is its Asian Convergence Index, the first product of its kind, which comes in two flavours: a narrow index that focuses on Asia ex-Japan and a broad index that includes Australia and Japan.
"The idea is to capture an effect we see in the market and which we expect to become more pronounced," says Hohensee. "The Asian central banks have a tendency to coordinate currency policy with one another. That could eventually lead to formal Asian monetary union, but far in advance of that it provides an opportunity which investors can take advantage of."
Convergence trades are similar to carry trades in that they exploit the carry between high- and low-yield currencies, but the difference is that convergence trades are driven by economic fundamentals rather than just yield.
Investors might get a huge carry between Turkish lira and Taiwanese dollars, for example, but the trade can unwind very quickly as one country shifts policy. The point with a convergence trade is that policy is coordinated, so investors are happy to give up some yield in return for greater stability.
To further hedge the risk Deutsche's index exploits the convergence trend by investing in bond markets, through swaps or other derivatives, rather than just in FX.
"The yen rally in September 2003 is a good example of the value in including rates exposure in a carry strategy like this," says Hohensee. "Equity investors' rediscovery of Japan caused a rally in the yen and squeezed carry trades, but simultaneously interest rates spiked higher to reflect the same economic fundamentals. So a short position in the rates market hedged away some of the losses due to the yen rally."
The risk that carry traders worry about is, simply, that the value of the low carry rises or that the high carry falls. With the rates-plus-FX strategy the risks are lesser: that the value of the low carry rises, while rates stay the same, or that the high carry falls at the same time as interest rates.
In Europe during the 1990s, convergence trades were relatively risk-free and easy to identify, and remain so today with new entrants such as Greece and Hungary, but the lack of an explicit single-currency policy in Asia makes it tougher to manage the trades. Deutsche's convergence index attempts to solve this problem by dynamically selecting trades according to relative risk, correlation and carry opportunities.
"It really doesn't matter to the strategy if a high carry pair becomes low carry," says Michael Parker, head of options trading for the global rates in Asia. "The optimisation takes care of that."
The result of all these features is a strategy that, since June 2002, has provided an annual average excess return of 5.55% for the narrow index and 7.29% for the broad index, as well as relatively low volatility of just 3.29% and 4.4%.
Investors can buy the index in a variety of ways: through standard options, tracking notes or notes that pay Libor plus the return of the index, or through a constant proportion portfolio insurance structure that provides managed exposure to the index and principal protection.