From Credit Agricole:

Central-bank policy divergence has reached an inflection point. The Fed has turned much more cautious on the longer-term outlook for rates while the BoJ and the ECB are inching closer to exhausting their ability to ease aggressively further.

Stabilising oil prices and inflation expectations of late further seem to be working against the divergence trade. Indeed, the Fed is willing to let the economy run hotter for now while other G10 central banks are increasingly reluctant to ease further.

Against this background, the G10 FX carry trade has staged a return, with investors exploiting the persistent divergence in the relative rate spreads between high-yielding and low-yielding currencies.

The G10 FX carry trade could continue to do relatively well for now underpinned by subsiding FX volatility, stable central-bank outlooks and fairly resilient global economic data. Also supportive seems to be the fact that the risks surrounding the US presidential election have subsided. In addition, the Italian referendum on 4 December is not expected to be a major stir for the markets either. Last but not least, while potential rate cuts by the RBA and the RBNZ could deal a blow to the performance of any long-AUD or long-NZD position, the muted impact that central-bank cuts have had on FX this year could mean that the bulls are unlikely to be deterred for too long. Stable FX ranges could boost the attractiveness of carry trades some more. The above being said, it's not going to be all plain sailing for the G10 FX carry trade.

In particular, we believe that two key risks could undermine demand for carry, especially as we move closer to year-end. On 8 December, the ECB is expected to announce more measures to extend the longevity of its ailing asset purchase program. The risk is that the ECB will fail to contain market fears about a QE taper, especially if the Governing Council announces plans for more aggressive credit rather than monetary easing. The result could be a further increase in long-term EGB yields, which could erode the attractiveness of EURfunded carry trades. Higher EGB rates could add to concerns about unwarranted tightening of global financial conditions as we head closer to the December Fed meeting. Indeed, we expect the Fed to hike rates and this could contribute to a (temporary) back-up in UST yields, similar to last year. Historically, higher long-term rates went hand in hand with growing FX volatility. The prospect of growing uncertainty could erode support for FX carry trades going into year-end.

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