The sub-prime market crisis was the catalyst that caused a rapid unwinding of the carry trade, which in turn precipitated the crash in the stock and commodity markets as fund managers were forced to raise liquidity to cover their extended losses in those two asset classes.
In a carry trade, an investor borrows and pays interest in a low-yielding currency (e.g. Japanese Yen) in order to buy a currency that offers higher interest (e.g. Australian Dollar).
Chart I: Cumulative Return on a balanced carry trade basket.
To build a balanced carry trade basket, an investor would take a position in the three currencies that have the highest yield, while selling the three currencies with the lowest yield. This portfolio is rebalanced on a monthly basis, while the volatility is scaled to 5%. From an academic perspective, the carry trade can typically be expressed as some form of the uncovered interest rate parity hypothesis (UIP). Based on the theory of efficient markets, the Uncovered Interest Rate Parity model would demand that the difference in interest rates between two countries is equal to the expected change in exchange rates between the countries’ currencies.
However, in reality the currency market is not efficient and provides an opportunity to generate profits that are uncorrelated to other asset classes such as bonds or stocks. Currencies are therefore an excellent asset class to add to a portfolio in order to diversify risk, while increasing risk-adjusted returns based on the theory from Harry Markowitz.
The best approach for trading currencies is a macro-economic approach in which a study of economic data from an individual country is used. You need to look at short and long-term interest rates, inflation rates, trade balances, budget balances, public debt, cross-border investment flows, trade weighted exchange rate and net non-commercial futures positions. This is not a comprehensive list but includes the most important variables that go into the trading model.
The name of the trading approach – “the carry trade” – already implies that it focuses on a positive interest rate differential. Therefore let’s start out by looking into this variable first.
Chart II: Nominal Short Term Interest Rate Differential USD / YEN
Chart II (above) demonstrates the positive correlation between the currency movements of the U.S. dollar against the Japanese Yen. The nominal interest rate represents the annualized return an investor obtains by having an exposure to this pair. You will recognize that the time lag between the interest rate movement and the currency movement shrinks as more investors apply sophisticated models to benefit from this inefficient market. The art going forward will be to correctly predict the interest rate differential within the next 12 months. A good leading indicator is the futures market, which implies the forward rates reasonably accurately. This approach does not hold under severe stress such as the Asian crisis in 1997 and during the recent financial crises. Therefore I would highly recommend staying away from any “black box models” in which traders believe they can correctly predict the future movements of the market by using a Monte Carlo simulation, for instance. The above indicator becomes stronger if you add the real interest rate differential as second indicator by considering the inflation rate differential between the two countries.
Chart III: Net Non-Commercial Futures Position
In the chart above we demonstrate another positive correlation between the FX movement and the net non-commercial futures position that provides a leading indicator of where the funds of the speculative community are flowing to. The Commitments of Traders (COT) reports provide a breakdown of each Tuesday’s open interest for market reports in which 20 or more traders hold positions equal to or above the reporting levels established by the Commodity Futures Trading Commission. As mentioned earlier, I am only showing a small selection of indicators – however, the principal applied to the other indicators is the same, in which a positive correlation is established between the indicator and future FX movement. The macro-economic model has a time lag of three to 18 months, therefore a trader needs to weigh the different variables in order to build a strong model, rather than relying on a few variables. In addition, traders are well advised to use a cost-averaging approach to optimize the results.
The movement of nearly all of the major currencies to 1% or below has changed the game for carry traders. Even prior to the recent market turmoil, the U.S. dollar had moved to a short option in many carry models. Now such typically strong currencies as the Canadian and Australian dollars can be used as shorts in carry trades while more obscure currencies like the Brazilian real is a long option.