Carry trades always have been a popular strategy for forex traders. The idea is not complicated. In a carry trade, traders sell currencies yielding low interest rates vs. currencies with a higher interest rate. These are medium- to long-term trades, as the spread between interest rates changes infrequently.
Unfortunately, although simple in execution, a profitable carry trade is a bit more sophisticated than simply selling a low interest rate currency, like the yen, against a high yielder, such as the Australian dollar (see "Yen for Aussie," below). While this trade indeed can work consistently, you need to understand the intricacies of what's occurring to protect your profits. Let's see why.
An interest rate story
Traders naturally flock from low-yielding to high-yielding environments. For instance, the traditional currency to sell has been the yen, as the Bank of Japan has been forced to keep rates virtually at zero for many years because of Japan's disinflationary economy.
This situation has persisted since the mid-1990s, making it profitable to borrow Japanese yen to fund activities in other currencies. Conversely, the rapid and sustained industrialization of China meant economic success for the raw materials-rich antipodean economies, and high interest rates made the Australian and New Zealand dollars the favorite currencies to buy not only for the yield-starved Japanese investors, but for traders around the world (see "It's all in the interest," below).
As much as we are trained to think of AUD/JPY and NZD/JPY as the standard carry trades, in reality the U.S. dollar increasingly has matched the yen in qualifying as a funding currency between 2000 and 2008, and again since 2009. "Don't forget the buck" (below) shows the monthly chart of AUD/JPY, NZD/JPY, AUD/USD AND NZD/USD. This long-term chart shows that since early 2009, NZD/USD made the sharpest gains and NZD/JPY the smallest profits.
As "Yen for Aussie" shows, AUD/JPY had a significant uptrend between 2000 and 2007, during which it advanced from 55.50 to as high as 108.00, nearly doubling in value. By early 2007, it was estimated that some $1 trillion may have been staked on the yen carry trade. It then collapsed during the infamous 2008 crash to 55.00 and then posted a sharp new uptrend, which to date has reached the 90.00 area.
The cross currency pair followed fairly accurately the path of the interest rates differential between Australia and Japan. While Japanese borrowing costs remained inert near zero, Australian interest rates peaked at 7.25% in 2008, tumbled to 3% through 2009 and then were hiked back to 4.75% by late 2010.
Carry trades make trends
A trend forms when there are divergent economies and, consequently, interest rates in various countries. The persistent demand for one currency vs. another creates either medium- or long-term trends. Thus, traders can ignore lesser or temporary factors with regard to the high-yielding currency of a carry trade. You could say that while all currencies are equal, some are more equal than others.
When it comes to the Australian economy, for instance, the general importance of a weaker monthly economic indicator is muted relative to the might of the Chinese demand for Australian raw materials. A single report doesn't make a trend, but uninterrupted flows of ore exports do.
Likewise, even natural disasters may not trigger a significant market reaction with regard to a carry trade. For instance, New Zealand suffered extensive damage from an earthquake in 2011. However, this unfortunate event did not significantly impact Kiwi exports to China, and the New Zealand dollar remained firm vs. both the Japanese yen and the U.S. dollar. This was not an easy feat, given that the Kiwi interest rates remained below 3% since April 2009 after peaking at 8.25% a year earlier. Other disasters have much more impact on currencies, however.
It is important to remember that the carry trade puts the odds in your favor. While anticipation of a positive carry spread growing can lead to a trend, absent a trend, a carry trade earns you the interest rate differential. You earn the positive carry on a position if it remains flat. Many traders will apply a carry trade overlay on their forex trades, only taking a position that earns positive carry. However, this positive carry cannot make up for a huge reversal in a carry trade that has become oversubscribed, as occurred in several currency pairs in 2007 and 2008.
Not just a one-way street
The big risk in a carry trade is the quickly shifting appetite for risk. It is vital to remember that foreign exchange is the most immediate and successful shock absorber of international imbalances. Demand for high-yielding currencies vis-à-vis the low yielders only works when the appetite for risk is high.
Consider the proverbial Japanese housewife, Mrs. Watanabe. Concerned with funding her children's education and her husband's retirement, she happily will withdraw money from the Japanese bank where she had parked her savings for zero interest and invest it in Australian dollars or even stocks.
But she will do so only when she thinks the world is in a good place, in which she feels confident to invest. Her appetite for risk will be strong when she learns that Japanese exports of high value-added products are strong and the Chinese economy is as sound as ever. Conversely, Mrs. Watanabe will turn risk averse when the Eurozone gets hit by new waves of debt crisis or U.S. consumer confidence plunges, spelling demand trouble for Japanese exports. If and when she sees dark cloud cover, she will exit those daring foreign investments and bring her hard-earned savings back to the safety of the zero-yielding Japanese bank deposits.
In Mach 2011, the exceptional earthquake and subsequent tsunami dealt a heavy blow to Japan. The initial reaction in the forex market was to dump yen because the two-pronged natural disaster blow, which maimed the Japanese nuclear energy infrastructure, was seen as a negative for both the economy and the currency; however, the Japanese yen had to be brought back to the safety of home in a hurry during the unexpected storm, so the AUD/JPY carry trade's 10% collapse only lasted for a few days.
It doesn't need to be a natural disaster to rain havoc on carry trades; people can do that too. For instance, the Bank of Japan has been known to tighten the money supply suddenly. When it does, the yen surges, squeezing carry trade speculators who were forced to repay their yen debts out of their positions. Consequently, a strong appetite for risk remains the major peril for carry trades.
Beware emerging currencies
While the standard pairs for carry trades are either AUD/JPY or NZD/USD, all that is needed to form a carry trade is a low-yielding currency and a high-yielding one. If, indeed, this is the only filter for the trade, then numerous emerging economies' currencies qualify as high yielders. Examples include the Icelandic krona and Brazilian real.
Some money managers seeking new opportunities in the latter part of the first decade of the 21st century came across Iceland, the tree penurious and sulphur-rich nation, whose micro economy offered gargantuan double-digit interest rates (but no discernible banks). Who could resist the attraction of such a rewarding carry trade, when at the peak in 2008 the Icelandic interest rates were at 18%?
In the end, however, most managers who didn't resist were painfully penalized. The massive financial crisis that started in 2008 triggered the collapse of all three of Iceland's major commercial banks and a surprise run on deposits in the United Kingdom. By December 2008, the Icelandic krona had plunged. Interest rates are now at a more pedestrian 4.25%.
Naturally, not all emerging markets provide horror stories for carry trades. Brazil, for instance, remains a success story in some ways and is increasingly being viewed as a major. With a booming economy and consistently high interest rates — they were below 10% only for about a year starting in 2009 as a result of the financial crisis — the Brazilian real has surged since December 2008. Yield-seeking investors have so far defeated sustained efforts of the Brazilian central bank to stave off the uptrend of the real. But the real's non-deliverable forward status presents challenges for less sophisticated investors (see "Real concern," below).
No end in sight
Over the years, there have been rumors of the end of the carry trade. This is a statement that should make any experienced trader uncomfortable. Interest rate differentials are one of the most persistent, most enduring truths of the world economy. True, conditions will change for specific pairs, but carry trade opportunities will persist. Indeed, with no up or down bias in the currency markets, despite any collapse, profits also can be had on the short side.
Looking forward, it appears today's standard carry trades will remain valid. Interest rates in Japan and the United States will not be hiked anytime soon, even though the latter will advance ahead of the former. Thus, the composition of currency funding will remain unchanged. Conversely, rates will remain high in the antipodean economies.
However, the risk there is the relative slowdown of the Chinese economy, particularly in light of the three rate hikes in 2011 and with an additional one in the works. A more sustained decline of the Chinese economy could result in fewer exports from Australia and New Zealand, but this is unlikely. Therefore, the AUD/JPY and NZD/JPY should see choppy and slower growth for the rest of 2011.
Cornelius Luca is president of LGR – research and advisory. He has been an adjunct professor at New York University (NYU) and authored numerous books on forex trading and technical analysis. Cornelius has developed, lectured and coordinated seminars on foreign exchange, technical analysis and capital markets since 1990. Follow him at www.LucaFXTA.com
