From the May 01, 2010 issue of Futures Magazine • Subscribe!

The carry trade is back

With the first quarter of 2010 behind us, interest rate differentials have emerged as the dominant fundamental force and key driver of currency movements. In other words, currencies associated with increases in interest rates should rally. This is a return to a more “normal” pattern that preceded the global financial crisis. After the Lehman Brothers collapse in September 2008, risk aversion became the dominant fundamental force. Consequently, currency flows followed a path to safe-haven baskets. During this period, there also was a liquidity crisis and a global shortage of dollars due to the de-leveraging which occurred. The dollar and the yen were the primary beneficiaries of this flow. The global financial crisis was very severe, as global GDP in 2009 contracted by an estimated 0.8% and world trade volume declined by 12%. We are still feeling the effects.

During the financial collapse, the U.S. dollar strengthened in a panic-driven atmosphere. The financial collapse also was characterized by unprecedented quantitative easing by central banks and along with it extremely low interest rates. In this period, interest rate expectations as a major force for currency valuation lay dormant. But it is a sleeping giant that is now awakening. The signs of pre-financial crisis conditions are present. One manifestation of a more normal financial situation is the three-month LIBOR (London Interbank Offered Rate)/OIS (overnight indexed swap) spread, which is near pre-crises levels. Expectations of a U.S. recovery have strengthened as U.S. private sector jobs have risen to the highest levels in three years. But how do you translate a global recovery into forex trading strategies? Which currencies will be favored? Which will be punished?

The shift in global economic conditions to an “expected growth” mode brings into play the traditional carry trade. This trade works by selling or borrowing low interest currencies and buying the higher interest paying currencies. It is a play on interest rate differentials. In a sense, there always will be a carry trade as long as there are differences in interest rates between countries. In pre-crisis years, the Japanese yen was the favorite carry trade currency, as the yen held the status of the lowest interest rate currency. This was followed to a lesser degree by the use of the Swiss franc and even the U.S. dollar. Forex traders would play the carry trade by selling these currencies against currencies offering higher rates such as the British pound, Australian and New Zealand dollars. The world became afloat in borrowed yen and U.S. dollars. This trade strategy collapsed as trillions of yen and U.S. dollars had to be quickly bought back during the global de-leveraging that occurred.

However, now with global conditions changing toward growth, the carry trade is back. Evidence of this can be seen in the price patterns of Barclays Bank PLC USD Intelligent Carry Index (ICI). ICI allows you to view and participate in a managed approach for a carry trade strategy without trading in the spot market.
However, ICI calculates the carry trading only using G10 currencies. As the carry trade rebounds, emerging markets will provide strong opportunities. India, Brazil, and Russia should be considered. India’s central bank recently increased rates to 5% from 4.75%. India’s inflation pressures could push rates higher. Its current GDP growth rate is 7.2%, with expectations for growth to be as high as 8.75% in the coming year. Buying the INR (an ETF based on the value of the rupee vs. the U.S. dollar) is a way to participate in rupee appreciation.

The Brazilian real’s (BRL) current interest rate of 8.75% provides one of the highest interest rate differentials against the USD or the yen. The Brazilian Bovespa Index also just experienced a 22-month high, showing increased demand for Brazilian assets. The Russian ruble (RUB/USD) has become a carry trade target with both a high interest rate, 8.25%, as well as strength correlated with a bullish oil market. While using exotics can produce larger interest rate differentials, they also bring added volatility and liquidity risk, so that must be worked into the equation.

For those who want to put on a traditional carry trade, the Aussie and New Zealand dollars are solid high interest rate currencies vs. the yen. You could even consider the U.S. dollar vs. the yen if you believe in a U.S. recovery occurring faster than Japan. It is also a play on the Federal Reserve either increasing rates or becoming more “hawkish” in its orientation. Even though the interest rate differential is very small now, it is likely to widen.

The carry trade does not guarantee profits, and in many cases can set up large losses when it gets overdone. But when markets are following traditional fundamentals, it offers steady returns when followed judiciously.

Abe Cofnas is the author of “The Forex Trading Course” and “The Forex Options Trading Course” (Wiley). Reach him at

About the Author
Abe Cofnas

Abe Cofnas is author of “Sentiment Indicators” and “Trading Binary Options: Strategies and Tactics” (Bloomberg Press). He is editor of newsletter and can be reached at

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