New York: A strategy to invest in higher-yielding assets using low-interest-rate currencies will remain in favour in 2010, with sterling stepping in alongside the US dollar as the prime currencies financing these trades.

Asset managers at Reuters Investment Summit in New York this week said sterling is their least favourite currency, sullied by low interest rates and by a slew of spending cuts and tax increases.

In the case of the greenback, investors have taken advantage of near-zero interest rates in recent months, borrowing huge sums in dollars in carry trades to achieve better returns.

"As long as the US continues to remain in a negative real interest rate environment and the interest rate hikes are not aggressive enough, the dollar carry-trade could go on," said Jonathan Xiong, director and senior portfolio manager at Mellon Capital Management.

Yen's loses out

The yen had been the market's favoured funding currency up until 2007. That changed in the summer of this year as the cost of the benchmark three-month interbank dollar funds fell below those of the yen, helping spawn the now-popular dollar carry trade.

The ICE Futures' dollar index, for instance, has fallen roughly 6.2 per cent so far this year against a basket of currencies.

The use of the dollar and sterling as funding currencies in carry trades is expected to weaken both units next year, the money managers said.

Bill Gross, co-chief investment officer of Pimco, the world's biggest bond house, believes a weak dollar would help address the imbalance created by a huge US current account deficit. "But in the process, [a weak dollar] also promotes the dollar carry trade and we recognise that," he said.

Sterling falters

A tepid economic recovery in Britain is expected to keep UK interest rates at a low 0.5 per cent, further pressuring sterling. On Thursday, the Bank of England left interest rates on hold as expected and kept its £200-billion asset buying programme under review.

"The last to raise rates are supposedly the US and the UK. Until then, with rates zero, it's hard enough to think that the carry trade won't continue," said Bob Doll, a vice-chairman of the world's largest asset management firm BlackRock.

And Gross described the United States and Britain as "two of the most grievous examples of irrational exuberance", or countries with high deficits and huge debt levels.

Sterling's trade-weighted index is up 8 per cent so far this year, but the pound has fallen about 4.6 per cent against the dollar since August.

So far, analysts said there has been no evidence yet that sterling is being used as a funding currency. One of the signs that a currency is being used to finance carry trades would be an increasingly negative correlation with the stock market via the S&P 500.

In carry trades, the stock market usually rises suggesting increased investor appetite for risk, while the currency often used to finance the purchase of risky assets typically falls.

The negative correlation between the dollar index and the S&P 500 has been strong. On Thursday, the correlation was -43 per cent.

In the case of dollar/yen versus the S&P 500, the correlation was 30 per cent, down from as high as 70 per cent in mid-September, suggesting that investors are increasingly moving away from the yen as the funding currency in carry trades.

Sterling has not ascended as of yet. The British currency has a minor 17 per cent positive correlation with the S&P 500, according to Reuters data, although analysts said that could change next year.

As for carry recipients, fund managers point to the usual suspects — the Australian and New Zealand dollars.

Australian dollar gains

Australia was the first Group of Seven economy to raise interest rates this year, tightening three times to 3.75 per cent, the highest in the developed world.

New Zealand dollar firm

New Zealand, on the other hand, has yet to raise rates from the current 2.5 per cent, but its central bank on Thursday signalled rates could go higher sooner than many thought.

Mellon's Xiong said the Australian and New Zealand economies may recover to approach "trend growth" soon.

In contrast, Japan, Eur-ope, Britain and the United States are lagging.

Real rises

Brazil also figured prominently as one of the top investment destinations for fund managers at the summit.

Max Darnell, chief investment officer at First Quadrant, said he is bullish on Brazil and his firm is launching a fund that will invest in the Brazilian real.

The real was up 31.4 per cent versus the dollar, partly driven by the benchmark interest rate at 8.75 per cent.

30%

the dollar/yen correlation with the S&P 500