Experience shows that the most important driver of currency trends is the interest rate differential of central banks. Many financial strategies attempt to capitalize on this knowledge, but the most basic and widespread strategy is the carry trade, see a shorter description of it here. In this article we’ll take a look at the basic aspects of this strategy and in the end give you links to further reading.
The carry of an asset is the return gained by holding it. For instance the carry on a Treasury bond is the interest received. The carry of a bar of gold held at a bank safe is negative, since the owner gains no positive return, but has to pay the bank a fee in return for the perceived security of the asset. Let us note that “carry” is unrelated to the speculative appreciation or loss on the asset value, but is merely the opportunity cost of owning the asset, positive or negative. In the case of currency trading, the carry is the interest return on the position as it rolls over to the next day. By shorting a currency with a low yield, and paying the negative but negligible carry return, and buying one with higher yield, the trader aims to make a profit which is then multiplied by leverage. The most popular pairs for carry trading are: NZD/JPY, USD/TRY, AUD/JPY, AUD/USD, EUR/JPY and BRL/USD. There are other, more volatile, less liquid pairs that are offered by various brokers, but the beginning trader can at first confine his activities to the most liquid ones above.
Carry trades could be ideal when central banks increase interest rates, but could be extremely risky in the wrong situation
Before moving on, we should note here that there are two kinds of situations that lead a central bank to maintain high interest rates, and only one of them constitutes the ideal conditions for the carry trade. These two situations are not in fact independent, but to make matters simpler for the forex trader, we will examine them as if they were. In short, central banks raise rates in response to the risk of both inflation and capital shortage. In the case of capital shortage, the central bank aims to stem capital flight out of a nation’s financial system, and it raises the main interest rate to lure investors and speculators to deposit funds in the nation’s banks. In the case of inflation, the central bank raises rates because there is too much money floating around in the economy, and by raising interest rates it aims to make the cost of borrowing higher, squeezing liquidity out of the system, contracting money supply, slowing the economy down and reducing the risk of inflation.
Of these two scenarios, the trader should only be interested in the inflation-induced one where capital flight is not a problem for the foreseeable future. Attempting to carry trade in an environment where interest rates are going up because of capital flight and panic is an extremely risky endeavor, and should be avoided as much as possible, unless the trader knows what he is doing, is very knowledgeable about the financial status of the country, and is comfortable with the risk he’s taking and the capital he allocates. Not only does capital flight increase the frequency and duration of volatility, but it also has the nature of a feedback loop, in which the situation deteriorates with great speed, and with little warning.
Use leverage – but be cautious
Carry trades depend on the principle that the interest rate differential between two currencies can be amplified by the successful usage of leverage, and that during periods of low volatility, the amplified profits can be compounded and reinvested to create massive returns over the longer term. If you have any experience with currency trading, you are already aware that the carry of an unleveraged forex account is usually minuscule, and it’s not possible to achieve meaningful returns unless you are willing to wait for a number of years. By utilizing leverage the carry trader aims at quicker profits, and justifies his choice on the premise that he’s always on top of his brief with respect to market developments, and will not be caught in the dark when there are periods of serious, but usually temporary shock and panic.
Since higher yields also attract capital and cause the currency to appreciate against its competitors, the returns are not limited to the leverage-enhanced interest gains that the carry account accumulates. The permanent gain in interest income actually allows the account to react to currency price fluctuations better by adding an interest income generated buffer zone to absorb them. Nonetheless, our general suggestions on sensible practices are valid in carry trading too: leverage higher than 10 is not really advisable, and one should never risk more than his risk capital.
Carry trading and fundamental analysis
The carry trade is sometimes advertised as a trade based on fundamental analysis in that higher interest rates indicate healthier economic growth, while steady capital flows reflect the underlying strength of the higher yielding currency. Nonetheless, on closer examination, we may not be very convinced by this argument. We know that the carry trader will long high-yield currencies such as the Turkish Lira, or the Australian dollar, and short those such as the Japanese yen, or the Swiss Franc. What do we notice in this type of currency allocation? First of all, many of the lower yielding currencies are reserve currencies as a result of their higher technological advancement and status as financial centers. Secondly, because nations raise interest rates, in many cases, to attract capital, they are likely to suffer higher volatility at times confusion and crisis. Third, the majority of high-yield currencies are issued by emerging markets where political instability is more frequent than it is among more advanced nations.
These observations should alert us to the fact that the carry trade sometimes entails trading against the fundamentals of the currency pair. Buying the currency of a nation with large deficits can hardly be said to be a safe and sound practice, but it may be profitable if there are too many people engaging in it. Similarly, shorting a currency backed by healthy surpluses is not safe under usual circumstances, but government policies, market behavior, and the general economic conditions may, at least on a temporary basis, reverse this rule. The carry trader follows the trend, and in that sense this method is more related to technical than fundamental analysis. There’s nothing wrong with that per se, but it is wrong to have false confidence based on the misleading association between high interest rates and economic strength.
Finally, we should remember that the carry trade is a directional bet. The trader basically forms his opinion, and acts in accordance, without giving much attention to the aspects of hedging or diversification. Since, at least during the past decade, the major carry trade pairs such as USD/TRY, NZD/JPY, GBP/CHF, or EUR/JPY all reacted in a highly correlated manner to fundamental shocks, an account that consists mostly of positive carry generating pairs cannot be thought to have diversified successfully. It is advisable that the trader either keep his leverage low, or hedge through the addition of some negative carry pairs into his portfolio, whichever he finds more comfortable.
The currency carry trade reached the bubble stage over the period between 2001-2008. As Japanese and Asian savers, tax haven-based large hedge funds, and other investors from all walks of life participated in this lucrative activity, at one point the amount of money invested was estimated as high as 1 trillion US dollars. Today the carry trade is still alive and well, but at a quite smaller scale than in the past as a result of the well-known global economic turmoil of 2008. Some of the highly leveraged players such as the aggressive hedge funds have been wiped out during the oil collapse and the successive waves of deleveraging that followed it, but those who were quick to cash out and realize their returns did indeed leave with tremendous profits. And of course we should not forget the massive gains registered even before the financial crisis began in the autumn of 2007. The carry trade did indeed create millionaires of those who were prudent in their choices, and relatively quick in their reactions.
Sound principles for the carry trader
Here are a number of principles that the carry trader can keep in mind:
- Follow all the rules of sound money and risk management. Carry trade is just another aspect of currency trading, and all the rules of the latter are valid here too.
- Carry trades are very sensitive to periods of insecurity and confusion. Anything that threatens stability and GDP growth is likely to be detrimental to the carry trade, even if the relationship is elusive at first glance. Hurricane Katrina caused a lot of disruption even to non-USD based carry trades, and the difference between stability and instability is often only a function of trader psychology.
- Do your research and understand the economy of the currency which you trade. Are you comfortable with the nation’s deficits, its development strategy or the risk level it poses to your portfolio? Manage your leverage in accordance.
- Since we desire to minimize the impact of short term fluctuations on our portfolio, the interest bearing positions must be open for months, at the very least. The carry trader must have a long term vision in order to avoid the temporary impact of volatility on the account.
- Analyzing the historical volatility of the high-yield currency, examining the usual speed and range of its reactions to important economic events of the past can be very helpful in determining the stop-loss point of the trade. For instance, during the period of 2000-2007 the Norwegian Kroner, despite its fundamental strengths, was prone to react in somewhat stronger percentage terms to news shocks and market volatility in comparison to the behavior of other currencies. Similarly, the Turkish lira, while stable most of the time, could be extremely volatile in reaction to banking sector problems. The trader should make sure that he is prepared for such periods, at the very least on a mental basis.
- The trader should be aware of developments of international scale. The health of the carry trade, volatility, and liquidity of the market all strongly depend on the health of the global economy, and the phase of the business cycle. Carry trades can enter long, deep periods of liquidation in response to global shocks, as in the aftermath of 1998 Asian crisis, or the turmoils of 2008. It is therefore a good idea to be up-to-date with the fundamental developments.
On a concluding note, let us remind you that the carry trade is a proven long-term strategy that has the potential to create spectacular returns for the patient, compassionate and diligent trader who is not afraid of realizing profits or taking losses when events, backed by fundamental analysis, dictate that he do so. The carry trade is a trend following strategy, and requires little sophistication from the trader in order to be successful. But it is very important to have a clear idea on what you expect from your carry trading account. Are you confident about your analysis that you’re ready and able to ride out temporary, but severe shocks in return for long term gain? Or are you holding the position overnight to realize short terms returns and exit with quick profits or losses? Your responses to these questions, along with your analysis of the global economic environment, should guide your choices with respect to this popular, proven and profitable trend-following strategy.
For further reading we recommend reading about the risks with carry trading.