If you have never heard of the carry trade, it is time to get familiar with it. Ask any long time forex trader and they will tell you that in the past 15 years, the “carry trade” has been the most popular and alluring strategy for currency traders large and small.
In fact, right now as we speak, over $6 trillion dollars is parked in this trading strategy by everyone from the largest hedge funds to the smallest individual retail investor.
Even conservative housewives in Japan who control the family purse enthusiastically embraced this strategy.
For five straight years, the carry trade was lucrative and easy. Between mid 2002 and 2007, a typical Australian dollar / Japanese Yen (AUD/JPY) carry trade generated more than 72% in slow and steady returns.
All a Japanese investor needed to do to participate in this trade is convert Yen into Australian dollars. U.S. investors could simply open up a forex trading account and buy AUD/JPY with a click of a button.
However, what made the trade sexier was that in addition to capital appreciation, investors earned a hefty yield. In early 2002, a long AUD/JPY trade earned an annual yield of 4.5% and by mid 2007 that rate increased to 6.5%. During this time in Japan, interest rates were where they are now – zero – and so Japanese investors scoured the world for higher returns. Americans did the same at the beginning of this period when the official interest rate was only 1.75% (and Australia’s was 4.5%); but by mid 2007, the gap between Australian and U.S. rates was only 1.25%.
But why are we talking about a trade that was popular 15 years ago?
Because during the Global Financial Crisis, investors learned about the ugly side of the carry trade – all of the gains incurred over a 5 year period were wiped out in a matter of 3 months. It didn’t take long for the trade to recover…but it was never the same. The “new carry trade” took on a completely different look and now it poses the greatest risk to investors – $6 trillion is not a small sum.
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When the Fed cut interest rates to zero after the crisis, it flooded the system with cheap dollars. A carry trade strategy involves borrowing in currencies with low interest rates and using those proceeds to fund purchases of assets with higher rates. So, when interest rates in the U.S. were slashed to 0.25%, the U.S. dollar became the #1 funding currency for carry trade.
Big investors could borrow $100 million, pay only $250,000 in interest and park that money into any other high yielding asset, such as Brazilian Reals, and earn 11% return or $9.75 million. Of course, this required the Real to remain unchanged or increase in value.
Now that the Fed is getting ready to raise interest rates, you’ll hear the term carry trade used more often as investors unwind their short U.S. dollar positions. The process has already begun and so far its consequences have been far reaching – from driving commodity prices lower, to sparking currency wars around the world. A 25bp hike won’t matter much in terms of interest payments.
But if the Fed raises interest rates two, three or four times next year (which would still fit the definition of gradual), then more carry trades will be unwound and this process could send the dollar higher, affecting markets around the world.
Thankfully there are ways to ride the carry trade unwind by buying dollars against currencies of countries with a strong reliance on commodities.
Selling Canadian dollars, Australian Dollars and most importantly emerging market currencies such as Brazilian Reals are great ways to hedge or profit from the great carry trade unwind.
Until next time,
Ms. Kathy Lien is the Managing Director and Founding Partner of BKForex’s strategies. A leading foreign exchange expert with more than 15 years of forex market experience, Ms. Lien is also an internationally-published author of the best-selling book, “Day Trading and Swing Trading the Currency Market” (now in its third edition). She is also author of “The Little Book of Currency Trading” along with “Millionaire Traders: How Everyday People Beat Wall Street at its Own Game” through Wiley. Her extensive experience in developing trading strategies using cross markets analysis and her years of market research in predicting economic data surprises, serve as key components of BK’s analytical techniques. She is a regular contributor to CNBC Squawk Box and Sky Business Australia.