MS: Political, liquidity risks pose downside risk to long carry/short vol trades

Morgan Stanley analysts warn of potential dangers for popular investment strategies involving long carry and short volatility positions, stating that they are being unwound.

The report highlights how recent "election surprises" triggered an unwind of carry trades, citing examples like the French-German yield spread and European sovereign debt.

According to Morgan Stanley, "political and liquidity risks" pose significant downside risks to these crowded trades. This includes long positions in US equities, which they see as vulnerable if "political headwinds intensify" ahead of US elections.

While recent positive inflation data offered some temporary relief, Morgan Stanley analysts downplay their significance, viewing them as "one-offs."

They caution that the "narrow path for a soft landing" currently priced into risky assets could see significant corrections if concerns about the economic cycle re-emerge.

Furthermore, the investment bank says that in FX, a rotation away from carry to other drivers of returns has been a key theme for them, given the expectations of yield compression that would make FX carry vulnerable to vol shocks.

"This staple source of currency returns for two years finally met its reckoning as a series of VaR shocks eliminated most of carry YTD returns," adds the bank. "While certain high-yielders could recover depending on idiosyncratic developments, global FX carry remains vulnerable given lower yields; by contrast G10 carry is likely to be more resilient given sticky inflation."