Is There Still a Carry Trade in FX?
Over the last few weeks there I have noticed much confusion in the air regarding the state of the current financial markets and with so much political and economical news in the air, it’s far from surprising to hear the questions coming.
Anyone with a little experience in the world of currency trading is familiar with the impact that Central Bank Interest rates have on currency prices, and we are told to pay as much attention to this as possible so as to keep informed on all factors shaping exchange rates across the board. When reading about anything to do with FX and interest rates, you will find commentary on one aspect called the Carry Trade which is something I have been getting many questions about lately. It is a very important aspect of Forex and can be hugely helpful in analysis if you know what to look for, so let’s take a deeper dive into it.
The Carry Trade has typically been a trading strategy used by major investors and institutions to greatly increase the rate of return or yield which they are getting on their money. As we know, Central Banks around the globe have the power to change their interest rates regularly through economic policy. The higher the rate are, the more attractive the currency is to the outside investors. The lower those rates are, the less likely people are to hold their money in that currency. The difference between worldwide rates is dependent on the policies of the Central Banks themselves and varies from nation to nation, with some being much higher or lower than others at any given time. So how would an investor take advantage of this?
A good example would be to focus on a currency like the Japanese Yen. Traditionally, the Yen has held lower rates than most other currencies, mainly since the Japanese Bank wants to maintain a cheaper currency which in turn means that it is more affordable for other nations to buy Japanese exports. As we know,Japanis built on exports so a weaker Yen works nicely in their favor. Due to these factors, the Carry Trade evolved into a strategy where investors could borrow one currency with a low rate attached to it, like the Yen and then sell to buy or invest in another higher yielding currency like the British Pound, Euro and even the USD itself.
As a result of the carry, we would see long term trends develop over the years as more people would borrow and sell Yen to buy stronger currencies and get paid what we call the rate differential. As well as recovering this differential, the investor would also gain from the change in rates. Here is an example of the carry trade in full working order on the GBPJPY between 2004 and late 2007:
Do you notice how the trend of GBPJPY is in the same direction as the S&P 500 Index? When things are doing well in global markets, investors tend to build up a higher appetite for risk and are happy to use their profits to attempt strategies like the carry trade. At the time, rates in theUKwere above 6%, way more than inJapanwhere they were below 1%. That is a free 5% you would have been receiving, along with the major gain in pips. However, as we saw when the Credit Crunch reared its ugly head in 2008, all good things come to an end and the carry trade unwound in spectacular fashion:
Up until 2009, both charts are practically in perfect sync, but the “flight to quality” by nervous traders and investors who were closing their positions and going back to cash caused a shift and we see the collapse in both Stocks and the GBPJPY. As you can see, overall market sentiment will change very quickly, sharply adjusting the supply and demand for markets in the blink of an eye.