The Carry Trade Explained

Want to know one of the reasons why the movements of exchange rates can be so pronounced at times?

There are many reasons why exchange rates move.

The first thing to remember is that there are two sides to any currency story.

For example the current strength of the Australian dollar (the Aussie) is a product of Aussie strength and greenback weakness.

Now Aussie strength has a lot to do with the price of commodities, with the Aussie traditionally seen as a commodity currency.

The Aussie is also important as a trading currency because of its position in Asia, that is between the North American close and European opening. It's also important as an 'Asian' currency.

But another vital factor is the carry trade.

Despite being at so-called 'emergency' levels, Australian interest rates are actually high by international standards.
Japan 0.10%
Canada 0.25%
United States 0.25%
Switzerland 0.25%
Sweden 0.25%
UK 0.50%
Europe 1.00%
Taiwan 1.25%
Norway 1.50%
Korea 2.00%
New Zealand 2.50%
Australia 3.50%
Poland 3.50%

So if you borrow money in Japan at low rates of interest and then invest it in Australia at high rates of interest and the Yen-Aussie exchange rate either stays constant or the Aussie appreciates against the Yen, you end up making a truck load of cash.

But ...

If the Aussie falls against the yen as it did from late last year then you're stuffed and everyone runs for the door at the same time. This adds to what is often called 'momentum' in currency trades. Right now the 'momentum' is for a higher Aussie.

Anyway the following graphic from the Financial Times explains it much more neatly than I can do.
http://www.ft.com/cms/s/0/f3aec6c2-b99e-11de-a747-00144feab49a.html

See also Nouriel Roubini (2009) "Mother of all carry trades faces an inevitable bust", Financial Times, 1 November <http://www.ft.com/cms/s/0/9a5b3216-c70b-11de-bb6f-00144feab49a.html?nclick_check=1>

Roubini outlines what he calls 'the mother of all carry trades' involving US interest and exchange rates. The major financial issue at the moment is the growing financial bubble that has been reignited by low interest rates.

So what is behind this massive rally? Certainly it has been helped by a wave of liquidity from near-zero interest rates and quantitative easing. But a more important factor fuelling this asset bubble is the weakness of the US dollar, driven by the mother of all carry trades. The US dollar has become the major funding currency of carry trades as the Fed has kept interest rates on hold and is expected to do so for a long time. Investors who are shorting the US dollar to buy on a highly leveraged basis higher-yielding assets and other global assets are not just borrowing at zero interest rates in dollar terms; they are borrowing at very negative interest rates – as low as negative 10 or 20 per cent annualised – as the fall in the US dollar leads to massive capital gains on short dollar positions.

Now short dollar positions mean that investors are borrowing greenbacks to sell now ('going short') and pay back later when the greenback is (hopefully) lower. Of course the more that investors short the greenback the more likely it is to be lower. So what is the effect of low interest rates, quantitative easing and massive purchases of long-term debt instruments (the metaphorical printing of money)? According to Roubini it is

seemingly making the world safe – for now – for the mother of all carry trades and mother of all highly leveraged global asset bubbles.

But like all bubbles eventually they get pricked.

But one day this bubble will burst, leading to the biggest co-ordinated asset bust ever: if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments.

The question for risk-takers is how long should you stay in the market and what will cause the reversal.

Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed.

The thing for investors to weigh up is timing.

This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.